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.

Multiple Issues - When can you "rely" on the IRS; Did the Tax Cheat really beat the system; Jenkens & Gilchrist; and the 40% penalty issue surfaces again!

This past week there was a lot of interesting news that came around. The first issue really came out two weeks ago in an order issued by the United States Court of Claims in Evergreen Trading, LLC v. United States. I did not consider it worth mentioning it until I overheard a conversation between two distinguished tax planners with one of them bemoaning the IRS’s lack of guidance on a particular subject but then bragging about how he conducted a search on the IRS’s web-site to ascertain the IRS’s position which allowed him to render advice to the client.

I almost reached over and told the distinguished tax planner – what exactly are you relying on? – But, I didn’t. Rather it reminded as to Evergreen. The issue in Evergreen is rather straightforward - taxpayer wants to depose certain government officials that wrote Treas. Reg. §§ 1.752-6 and 1.752-6T. The Court correctly denied the request on the following grounds:

  • The personal views, intentions, etc. of the drafters of such regulations are not relevant in construing regulations or determining the validity thereof. See, Bankers Trust N.Y. Corp. v. United States, 225 F.3d 1368 (Fed. Cir. 2000). See also
    • Sidell v. Comm'r of Internal Revenue, 225 F.3d 103, 111 (1st Cir. 2000) (rejecting the taxpayer's reliance on a number of internal IRS memoranda to show that a proposed regulation was not meant to cover a particular situation); 
    • Conn. Gen. Life Ins. Co. v. Comm'r of Internal Revenue, 177 F.3d 136, 145 (3d Cir. 1999), cert. denied, 528 U.S. 1003 (1999) ("reliance upon remembered details from officials who lacked the ultimate authority to issue any proposed regulation has little support in the law"); 
    • Schwalbach v. Comm'r of Internal Revenue, 111 T.C. 215, 228 n.4 (1998) (giving "no weight" to oral statements made by "agents of the Commissioner" describing the content of final regulations); 
    • Armco Inc. v. Comm'r of Internal Revenue, 87 T.C. 865, 867-68 (1986) (affidavit of IRS employee explaining his intent in drafting a regulation irrelevant to interpreting the regulation); 
    • Vons Cos. v. United States, 51 Fed. Cl. 1, 21 (2001) ("this court [should be] extraordinarily hesitant to attribute to the IRS or the Treasury Department interpretations of a revenue ruling made by individual IRS employees that represent their personal views, rather than the official position of the agency").

Rather for purposes of reliance there is the code, case law, revenue rulings, revenue procedures, final regulations, at times proposed regulations, private letter rulings if you are the taxpayer that requested the PLR, certain notices and announcements. For a detailed list see IRM 32.2.2.10.

  • Note even as to case law there are limitations. See Stratmore v. Commissioner, T.C. Memo. 1984-547 (memorandum opinions are limited to their own “precise factual situation”). See Nico v. Commissioner, 67 T.C. 647, 654 (1977) (“We consider memorandum opinions of this Court to be controlling precedent”); McGah v. Commissioner, 17 T.C. 1458, 1459 (1952) (“our practice which is that memorandum decisions are not cited”); Andrews v. Commissioner, 931 F2d 132, 138 n.9 (1st Cir. 1991) (“We note that prior memorandum decisions of the Tax Court are not treated by that Court as binding precedent.”) See also Golsen v. Commissioner, 54 T.C. 742, 757 (1970) (Tax Court applies law of the Circuit)

Thus, for reliance I would not rely on the IRS’s web-site for penalty protection. To my esteemed colleague educate your client and tell him he should get a private letter ruling, as he can afford it. If the Client doesn’t want to, well he is going to have to comply with FIN 48 anyways so, he better get a tax opinion. But when you write the tax opinion, please do not cite the web-site as authority, as the IRS will view this as non-binding authority, i.e. see Evergreen.

Both the Wall Street Journal and Tax Notes Today reported the mess that is Walter C. Anderson. Yes, Department of Justice fumbled but let’s just say - the game as to taxes due and owing is not over. Knowing my friends at the IRS the jeopardy and termination assessments are coming down the pike. Thus, yes it was embarrassing but this does not mean he won’t end up paying the IRS what ever is determined to be the true and correct tax. That is assuming - well let’s not state the obvious.

Speaking of messes the Wall Street Journal and Tax Notes Today reported the demise of Jenkens & Gilchrist. For those that have read Diversified Group., Inc. v. Daugerdas, 139 F.Supp.2d 445 (S.D.N.Y.2001) such as the IRS (who probably went through that case file with a fine tooth comb) the fall of Jenkens should not come as a surprise. Being that as a Government attorney I fought these transactions and now as private practitioner have had to pick up the pieces for those taxpayers that were sold these transactions, I just wonder what were these venerable institutions thinking? I will not state the obvious but the message from the Federal Government is clear – tax shelters at then end of the day may be hazardous to the firm as institution and to the professional practitioner.

Finally there is Cemco Investors, LLC v. United States, - F. Supp. – ( N.D. Ill. 2007), were the issue of substantial valuation misstatement arose. Well let’s say the result was contrary to Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 WL 283790, (E.D.Tex.. 2007). The Court instead relied on Santa Monica Pictures, LLC v. Commissioner, T.C. Memo 2005-104. The Court could have gone with Gilman v. Commissioner, 933 F.2d 143 (2d Cir.1991), affg. T.C. Memo.1990-205 but they didn’t. Why not- in Santa Monica, the Judge attempts to distinguish the fully reviewed Tax Court opinion of Todd v. Commissioner, 89 T.C. 912 (1987) aff’d 862 F.2d 540 (5th Cir.1988). I guess the District Court found the tax court judge’s argument persuasive. Question: Since Santa Monica was only a T.C. Memo is it fair to say that the rest of the Tax Court did not find the judge’s opinion in Santa Monica as persuasive as the IRS alleges it to be. Santa Monica is currently on appeal. Stay tuned!

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.

Klamath, Estate of Kanter, and IRS's Announces Civil/Criminal Enforcement in Foreign Transactions

Two opinions were announced this week - Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 WL 283790, (E.D.Tex.. 2007); Estate of Kanter v. Commissioner, T.C. Memo. 2007-21. These two opinions were highly anticipated as they afforded the respective Courts an opportunity to interpret new judicial doctrines/rules and answer questions concerning the trial judge’s role in evaluating and determining witness credibility.

In addition, in three separate publications, the IRS’s criminal and civil intentions as to foreign transactions were broadcast.

The inherent facts and issues of Klamath are set forth in: Dawson, COLTEC: A New Standard for Economic Substance, Business Entities (WG&L) (Nov./Dec. 2006). As stated in the article, there were three issues worth following: 1) Whether the Court would refine its application of the economic substance test in light of Coltec? As stated in the article they might and the Court did. 2) In light of the 5th Circuit’s ruling in Todd v. I.R.S., 862 F.2d 540 (5th Cir.1988), would the Court impose a 40% penalty for gross valuation misstatement? As stated in the article the Court would not and it did not as a matter of law. 3) Would the Court impose a 20% negligence penalty? No opinion offered was in the article as it was viewed as a question of fact. Based on the Court’s determination concerning the credibility of the witnesses no penalty was asserted.

Issue #1. The Court in citing to Compaq Computer Corp. v. Comm'r, 277 F .3d 778, 781-82 (5th Cir.2001) noted that the Compaq “declined, however, to consider whether a court must invalidate a transaction that fails only one of the prongs of the test.” Noting this declination, the Court decided that indeed only one of the prongs must be found to fail the economic substance test and the appropriate prong to test is the event that creates the tax loss, i.e. did that event have independent business purpose other than the creation of a tax loss. The Court stated:

“When applying the economic substance doctrine, courts emphasize that the transaction to be analyzed is the particular transaction that gives 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).”

The Court then focused on the loan agreements and arrangements at issue and determined that the financial institutions and Presido never intended to implement the seven year plan. To the contrary, if necessary the financial institutions and Presido would have compelled the taxpayers to exit the strategy at the end of Stage I through financial pressure. In addition, Presidio’s fee arrangement as set forth in its Congressional testimony was predicated on the tax loss generated by the investment plan. Thus, taxpayer’s intent concerning the legitimate business reasons for the transaction was all for naught as Presidio and the financial institutions did not the “investment plan” in the same light.

From the Government’s perspective this could not be better news. The Court in the 5th Circuit applies Coltec and as stated in the blog of January 21, 2007 the Government’s use of pattern evidence was justified. That is, the Court stated that it can and should focus on the intent of all the parties of the transactions and not just the intent of the taxpayers. Thus, if the intent of one of the parties, i.e. a facilitator, and/or stage is dubious in terms of economic profit then the transaction will fail regardless of the taxpayer’s and the plan’s overall economic profit.

But as the saying goes the Government won the battle but lost the war. Taxpayer’s and their representatives have realized that as to the majority of these transactions it will be difficult to demonstrate that the investments have economic substance. (I still maintain that certain LILO’s may have economic substance even though RJT Investments ruling is to the contrary. See Blog dated January 14, 2007). Thus, the primary concern of many practitioners and taxpayers was/is the penalty(ies) issue.

As to the office of Chief Counsel, we have been hearing from them that the maximum amount of penalties would be sought and obtained. The IRS in various cases had done very well in obtaining the maximum amount of penalties it had sought. See Long Term Capital Holdings, Ltd. v. United States, 330 F.Supp.2d 122, 205 (D.Conn.2004); Santa Monica Pictures v. Commissioner, T.C. Memo. 2005-104. However none of the cases had been in the forum the IRS has sustained it’s more notable losses – the 5th Circuit. Well in this case the IRS not only failed to obtain the 40% penalty the IRS got zeroed out.

Issue #2 The IRS’s loss as to the 40% penalty was not surprising as it was based on a matter of law. Todd v. I.R.S., 862 F.2d 540 (5th Cir.1988); Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir.1990); Weiner v. U.S., 389 F.3d 152, 161-62 (5th Cir.2004). It is obvious that the IRS wanted to test the Court and see if they could get it to reconsider Todd as the Court in Santa Monica had done. One factor the IRS failed to consider was the forum it was in. In Santa Monica the forum was the Tax Court here it was a Federal District Court. [It should be noted that Santa Monica is currently on Appeal to the 9th Circuit]. Thus, the IRS losing on the 40% issue was not surprising.

Issue #3: However, the fact that no penalties were imposed is from the taxpayer’s perspective the victory that they have long sought. The reason is premised on how the Court arrived at its conclusion. The Court arrived at its conclusion by looking at the taxpayer’s particular facts and circumstance. The Court decision in Klamath as to the penalties focused on the primary role of the fact-finder – his assessment as to credibility of the primary witnesses. The Court found the taxpayer and their testimony to be credible. He found that they were not looking solely at the tax advantages of the transaction. To the contrary, the taxpayers had a continuous and ongoing relationship with their accountants and had asked their accountants to identify a firm that specialized in foreign currency trading.

The Court found the taxpayers to be credible when they testified that when they met with the representatives from Presido they had no discussions of tax issues surrounding the investments. Instead, the meeting was entirely devoted to the business opportunity being presented to the taxpayers. Rather, the Court found that from the time the taxpayers began considering foreign currency investments until the time they decided to invest with Presidio, their primary motives had been to make a profit. The Court found as credible their testimony that the reason for exiting the investment was due to other financial investments.

As to the tax advice received, the Court found the taxpayer’s evidence to be highly credible. The taxpayers sought the oral advice of a prominent tax lawyer who gave the transaction his blessing. (Compare with Long Term Capital). The fact that the taxpayers received a tax opinion from the law firm that represented Presidio was not troubling to the Court as the opinion was detailed, came from qualified attorneys, the taxpayer’s needed advice as to the transaction, and the taxpayers had determined for themselves that there was no conflict of interest with the opinion.

Needless to say, that part of the opinion is and will be a major blow to the IRS’s future endeavors in this area. For the Klamath Court has demonstrated a common sense resolution to the government’s argument of reliance of the “promoter’s agent” argument. The area is/was complex therefore why shouldn’t the taxpayer be entitled to rely on the opinions of reputable law firms? If the government says no, then the government needs to demonstrate that the taxpayers knew or should have known that the law firms in question were acting in a duplicitous manner. See Klamath’s opinion as to “Substantial Understatement of Income Tax”; “Disregard of Rule and Regulations” (“Contrary to the government's approach with respect to many of the other BLIPS investors, the IRS did not even bother to interview the taxpayers before it asserted the penalties. The court finds that no penalty should apply for disregard of rules or regulations.”) and “Reasonable Cause and Good Faith”.

Thus the government’s use of pattern evidence will be of limited value in the key issue in these cases – the imposition of penalties. If the question is of credibility of the witnesses, then the facts of the particular case will be of the up most relevance. Thus, the fact-finder, i.e. the particular judge’s, assessment of the witness and the evidence cannot be absconded by others. This brings me to the Estate of Kanter.

In Estate of Kanter, the key issue was the credibility of the witnesses. Tax Court Rule 183 states/stated and the Supreme Court noted that: “[d]ue regard ••• to the circumstance that the [s]pecial [t]rial [j]udge had the opportunity to evaluate the credibility of the witnesses,” must “presum[e] to be correct” fact findings contained in the report. . .” Ballard v. Commissioner, 544 U.S. 40, 45            (2005). Because of this failure to follow its own rules, the Tax Court’s decision in Kanter was overruled.

Tax Court 183 was subsequently amended and T.C. Rule 183(d) makes specific reference to the language cited by the Supreme Court. Curiously or rather enlightening,  the Kanter opinion does not highlight this language but rather highlights T.C. Rule 183(c) even though the Supreme Court and the 11th Circuit specifically brought to the attention of the United States Tax Court the above stated language of T.C. Rule 183(d).

Being that the case was one of first impression it is worth noting that the case was rendered as a T.C. Memo. opinion and not as a fully reviewed T.C. opinion. The Kanter opinion is over 450 pages long and is an attempt by the Court to explain to the 11th Circuit and the Supreme Court why the Tax Court’s original decision was correct and why the Special Trial Judge’s findings as to the witnesses and other key evidence should be given no weight at all.

The Tax Court interprets Tax Court Rule 183(c) as not providing a bar to new proposed findings of fact and leaves the matter within the discretion of the reviewing Judge. This is a rather broad read of T.C. Rule 183(c) as this interpretation gave the IRS and the Court the ability to make new findings of fact contrary to the findings of the Special Trial Judges report and contrary to the original findings proposed by the IRS awhich were objected to by petitioner’s counsel when the original trial and briefs were submitted. Simply stated we are not talking about Monday quarterbacking we are talking about Friday quarterbacking. 

Tthe Court’s docket sheet reflects a “no objection to the Special Trial Report” being filed by the Petitioners and Respondent filing an “objection to the Special Trial Report” rumored to be over a 1,000 pages long and certainly containing numerous proposed alternative findings of facts. One clear observation can be made as to Respondent’s alternative findings of fact - Petitioner was never afforded an opportunity to object to these alternative findings. Rather, according to the Court this is simply within the Court’s jurisprudence. Such an analysis by the Court’s is alarming and disturbing. This Court’s bedrock foundation is found in fairness amongst the parties and to the Court. Such fairness is found in the it’s discovery rules specifically the Branerton process, its rules as to expert testimony, and last but not least the Court rules concerning the briefing process under Tax Court 151.

Under Tax Court Rule 151, a party is afforded an opportunity to file objections to an opponent’s proposed finding of fact if said opponent has filed a brief in the case. Such position allows a party an opportunity to state for the record his/her/its objections to Respondent’s requested findings, i.e. it assures due process and does not allow Respondent or any other party an advantage in the brief processing. For this opinion to ignore such a premise/result and create a conflict as to its own rules is rather disturbing to all practitioners, i.e. is due process being ensured by this  ruling? 

Under its interpretation of new 183(c), the Court was given ample opportunity to ignore the STJ’s report and agree with Respondent and ignore the original findings as to the credibility of the witnesses. As the Court stated: “Thus, the Court does not feel constrained from correcting manifestly unreasonable findings of fact or making additional findings of fact, so long as any additional facts find direct support in the case record.”

In the ensuing opinion the Court reviewed Respondent’s requested additional findings of fact and for the majority of these new findings accepted them and rejected the STJ’s report as follows:

  • The Special Trial Judge misunderstood Respondent’s legal positions in the case. See for example the following findings made in the opinion:

o “The STJ report also incorrectly stated: "respondent's claim of fraud is not based, per se, on the payments by The Five to Kanter or any of the other entities to which such payments were directed.”
o “In addition, the statement in the STJ report limiting respondent's theory of fraud to the failure of Kanter, Ballard, and Lisle to report as income amounts "dropped down" to them in the form of loans is inaccurate and incomplete.”

  • Kanter’s testimony as well as other witnesses was in the eyes of Judge Haines unconvincing and advocacy in nature. See for example the following findings made in the opinion:

o “Errors in the STJ Report108- The STJ report was based on two fundamental misconceptions regarding respondent's position which resulted in (1) compelling evidence largely being ignored, (2) credibility determinations regarding The Five that were not relevant to a determination whether a kickback scheme existed among Kanter, Ballard, and Lisle, and (3) credibility determinations regarding Kanter, Ballard, and Lisle that were manifestly unreasonable. A detailed examination of the substantial record in these cases, along with a review of the parties' posttrial briefs, demonstrates that the ultimate holding recommended in the STJ report, i.e., that Kanter, Ballard, and Lisle did not participate in a kickback scheme, is directly contradicted by the overwhelming objective evidence in these cases and thus is manifestly unreasonable.”

In the next one hundred pages plus, the opinion details  the errors alleged to have been made by the sitting judge as to the credibility of the witnesses. Suffice it to say, that the opinion of this Judge is at odds with the opinion of the sitting judge. Suffice it to say that the observations of the Judge were made after Respondent had an opportunity to restate the record. Suffice it to say that the observations of the Judge were made over a number of years after the trial occurred and the witnesses are now deceased. Suffice it to say that it appears the instructions of the Supreme Court and the Eleventh Circuit appear to be ignored. Suffice it to say that we are looking at another Succession of McCord v. Commissioner, 461 F.3d 614 (5th Circuit 2006) or worse Dixon v. Commissioner, 316 F.3d 1041 (9th Cir. 2003) were now the Eleventh Circuit may be step in and by highly critical of the United States Tax Court..

Being that the Tax Court is an honorable institution and being that the opinion was not fully reviewed, I am forward enough to ask this honorable institution to vacate this decision on its own and determine whether Tax Court 183 was properly interpreted and applied in this proceeding.

Finally, in three different publications, (Tax Notes Today, the Wall Street Journal and BNA Daily Reports) the IRS announced that it intends to will include high-wealth individuals and tax practitioners in addition to business taxpayers under its new focus on coordinated international enforcement. See BNA Daily Tax Report for January 29, 2007. The BNA daily report stated that the “IRS will have some 500 of its 4,000 special agents trained in advanced international tax issues as part of the new strategy. Those agents will be segmented in "issue management teams" involving a number of technical issues, including foreign tax credits, hybrid arbitrage, and transfer pricing.” Call my blog of January  28th  a lucky guess.

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.

RJT INVESTMENTS X, LLC Tax Court's quick visit to the Son-of Boss store

Last April it was noted that the Tax Court had ruled against a taxpayer involved in a Son-Of- Boss case. It turned out the ruling was a one page order issued by Judge Laro. Judge Laro is one of the most respected judges on the United States Tax Court. Thus, a one page dispositive order as to a Son-of Boss case caught everyone’s attention. As suspected the case is now on appeal and the Government’s brief has been posted on Tax Analysts. See 2007 TNT 8-37.

The Government’s brief sets forth the issues as follows:

  1. Whether the Tax Court had jurisdiction to determine the partnership item components of the partner’s basis in his partnership interest in RJT.
  2. Whether the Tax Court had jurisdiction to determine that RJT was a sham, that it lacked economic substance, and that it was formed and/or used for tax avoidance purposes.

The reason for the issues being framed in such a narrow manner is according to the Government, the taxpayer conceded that the transaction had no economic substance and admitted that it would present no evidence in challenging the notice. Rather, according to the Government, the only issue was jurisdictional as the Court lacked jurisdiction over the sham issue and the issue over outside basis.

As they there are two sides to a story and we do await taxpayer’s version of the facts and the law to determine whether this case was worthy of the headlines it received from the IRS.



Mathia et al. v. Commissioner, T.C. Memo. 2007-4 The Importance Of The Stipulation Of Facts.

When I worked at the Office of Chief Counsel, Counsel’s advantage was it knowledge of the stipulation of fact process and Counsels’ appreciation of how the Tax Court viewed the importance of the Stipulation of facts. Succinctly stated, even before the trial started an artfully drafted stipulation of facts may position a party to victory. Mathia et al. v. Commissioner, T.C. Memo. 2007-4 reminds all litigants of the importance of the stipulation of facts process.

The facts in Mathia are rather straightforward. Taxpayers were partners in a TEFRA partnership. In 1990, the TEFRA partnership received a FPAA notice as to taxable years 192 - 1984. The TMP timely responded and by 2002 the TMP and the IRS had filed a decision document and a stipulation of settlement with the Tax Court. The Tax Court entered the decision and issued an order resolving the TEFRA litigation.

On January 2003, the IRS assessed the deficiencies against the taxpayers. The taxpayers paid the deficiencies but did not pay the interest relating to the deficiencies rather taxpayers sought an abatement of interest. The IRS proceeded with collection enforcement and taxpayers filed a timely petition. In their petition, taxpayer’s contended that the period of limitations on assessment had expired before the IRS had assessed taxpayer’s 1982 – 1984 liabilities and the IRS had improperly denied their interest abatement.

The IRS and the taxpayers negotiated over the stipulation of facts and submitted the case fully stipulated under T.C. Rule 122 to the United States Tax Court. In the stipulation of facts, the IRS stipulated that the taxpayer husband was not a notice partner or a member of a notice group. See sections 6231 (a)(8) and 6223(b)(2). Moreover, the stipulation provided that the TMP had the authority to bind all of the partners of the TEFRA partnership. See also Tax Court Rule 248, Settlement Agreements and the time requirements contained therein. One week before briefs were due, the IRS filed a motion for relief as to the two stipulated paragraphs as it “contained erroneous legal conclusions” but did not seek a motion to vacate the Court’s order as to the Rule 122 motion.

The Tax Court denied the IRS’s motion. The Court held and observed the following: 

  • The stipulation process is “the bedrock of Tax Court practice” citing to Branerton Corp. v. Commissioner, 61 T.C. 691, 692 (1974).
  • The stipulation of facts may be a matter of contract law wherein the stipulation of facts process allows the parties to concede both factual and legal issues that they might have otherwise litigated. “In fact narrowing disputes to the essential disputes issues is the primary function of stipulations”.
  •  A unilateral error, even if one of law, is not an exceptional circumstance and insufficient to set aside a stipulation.

The Court finally observed that if the IRS’s motion were granted then the Court would be compelled to have a trial, which not even the IRS wanted. To compel a trial would be an unnecessary burden on the parties and on the Court.

Observation: It appears that the taxpayers may be requesting a claim for refund as they are  contending that the assessments were untimely. The Tax Court in Hoffman v. Commissioner, 119 T.C. 140 (2002) left undecided whether it had jurisdiction over a refund claim in the setting of a due process hearing. It appears that the Tax Court may be revisiting this question in light of the Tax Court recently receiving from Congress sole jurisdiction over due process hearings under sections 6320 and 6330.

Announcement 2006-100: Appeals Closing Cases Involving Unsettled Listed Transactions

Announcement 2006-100 provides in relevant part:

"When a settlement cannot be reached by the Office of Appeals in a case that is not docketed in the Tax Court, it is expected that the case will proceed to litigation. The Service wants to ensure that it has fully developed the limited number of unagreed cases that involve listed transactions (within the meaning of Treas. Reg. § 1.6011-4) before it sends a statutory notice of deficiency (or other determination notice triggering litigation rights) to the taxpayer. Consequently, the Service is revising its procedures to provide that when the Office of Appeals and the taxpayer are unable to reach a satisfactory settlement in a nondocketed case involving a listed transaction, the Office of Appeals will close out its consideration, notify the taxpayer, and send the case to the appropriate Operating Division for further handling."

Announcement 2006-100 has created quite a stir. For an interesting discussion see Stranton, IRS Officials Defend New Approach to Appeals, Penalties. Vol. 52 TNT No. 13, p. 222 (December 29, 2006). In the article the statement is made: “Indeed some practitioners view the notice as an end run around discovery rules in court.”

Announcement 2006-100 provides in relevant part:

"When a settlement cannot be reached by the Office of Appeals in a case that is not docketed in the Tax Court, it is expected that the case will proceed to litigation. The Service wants to ensure that it has fully developed the limited number of unagreed cases that involve listed transactions (within the meaning of Treas. Reg. § 1.6011-4) before it sends a statutory notice of deficiency (or other determination notice triggering litigation rights) to the taxpayer. Consequently, the Service is revising its procedures to provide that when the Office of Appeals and the taxpayer are unable to reach a satisfactory settlement in a nondocketed case involving a listed transaction, the Office of Appeals will close out its consideration, notify the taxpayer, and send the case to the appropriate Operating Division for further handling."

Announcement 2006-100 has created quite a stir. For an interesting discussion see Stranton, IRS Officials Defend New Approach to Appeals, Penalties. Vol. 52 TNT No. 13, p. 222 (December 29, 2006). In the article the statement is made: “Indeed some practitioners view the notice as an end run around discovery rules in court.”

There is reason for this concern. It cannot be ignored that the Office of Chief Counsel has been emphatic that, as to Son-of Boss transactions, the IRS will vigorously pursue those taxpayers that did not participate in the settlement initiative. Message being delivered by the IRS: "Concede or be prepared to litigate."

Now it appears that the message the IRS is saying: "Hold it. We need time to prepare the case prior to sending the case for litigation." Private practitioners cannot ignore that the Office of Chief Counsel is highly involved in making sure that the Son-of-Boss cases are properly being developed. Moreover, these teams from the Office of Chief Counsel are further limited in terms number and personnel (i.e. litigators) while the Son-of-Boss cases are numerous (over 500 and some reports say over 1,000). Thus, it is not surprising that the Office of Chief Counsel wants the cases developed when the case is docketed not that the case has to be developed when the case arrives for litigation.

So what is that private practitioners are faced with: Counsel attorneys assisting the revenue agents through a plethora of the Son-of-Boss cases using IDR’s, interviews, possibly summons to develop these cases. In the meantime the private practitioner will not have access to the same information (see section 6103) while the IRS’s attorney has access to multiple years and multiple cases without fear of discovery and can develop the facts as they deem necessary.

Observation: Are we heading for another showdown similar to the Mary Kay Ash problem? In Ash v. Commissioner, 96 T.C. 459 (1991), the IRS successfully modified/overturned Universal Manufacturing Co. v. Commissioner, 93 T.C. 589 (1989), and Westreco, Inc. v. Commissioner, T.C. Memo. 1990-501. Will the Tax Court be sympathetic to the taxpayer?. If a guess was to be ventured – probably not. See Judge Swift’s concurring opinion in Ash v. Commissioner, 96 T.C. at 478 – 481.

Thus under this new policy let the obvious be stated - Leverage is in the facts. The IRS has only only a window of time to develop the facts. Therefore be careful when agreeing to the statute extensions being requested from the IRS as your leverage as to the “keys to the facts” may have been waived away – turned over to the IRS.

Lease-In/Lease-Out ("LILO") -BB&T Corporation v. United States

During my days working with the Office of Chief Counsel, I was fortunate to be involved in tax shelter litigation. In one of those meetings in Washington, D.C. a former deputy chief counsel uttered the phrase “not all LILO’s are bad”. Reason - LILO’s are factually intense. Surprise! A LILO case was decided through a motion for summary judgment – BB&T Corporation v. United States, 2007 TNT 4-19 (M.D. N.C. 2007).

BB&T, a financial service company, participated in a LILO transaction ("Transaction") with Sodra Cell AB ("Sodra"), a Swedish company, a world-wide manufacturer of wood pulp. The Transaction at issue involved the lease and sublease of the pulp manufacturing equipment (the "Equipment") at one of Sodra's pulp-manufacturing facilities.

During my days working with the Office of Chief Counsel, I was fortunate to be involved in tax shelter litigation. In one of those meetings in Washington, D.C. a former deputy chief counsel uttered the phrase “not all LILO’s are bad”. Reason - LILO’s are factually intense. Surprise! A LILO case was decided through a motion for summary judgment – BB&T Corporation v. United States, 2007 TNT 4-19 (M.D. N.C. 2007).

BB&T, a financial service company, participated in a LILO transaction ("Transaction") with Sodra Cell AB ("Sodra"), a Swedish company, a world-wide manufacturer of wood pulp. The Transaction at issue involved the lease and sublease of the pulp manufacturing equipment (the "Equipment") at one of Sodra's pulp-manufacturing facilities.

On June 30, 1997, Sodra and BB&T, through a trust, entered into the Transaction by executing a series of agreements. The Transaction consisted of a "Head Lease" in which BB&T acquired an undivided interest in the Equipment for a period of 36 years ending June 30, 2033 and an immediate shorter term sublease (the "Lease") of the undivided interest in the Equipment back to Sodra for a term of 15.5 years.

The Head Lease required BB&T to pay rent to Sodra in two installments. The first installment (the "initial Head Lease Payment"), approximately $86.2 million, was due on the closing date and was allocated to the first five years of the Head Lease term. The second installment (the "Deferred Head Lease Payment") of approximately $557.8 million was due in 2038, five years after the expiration of the Head Lease term, and was allocated to the last 31.5 years of the Head Lease term.

At Closing:

  • BB&T paid the Initial Head Lease Payment with $18,228,895 of its own funds plus $68,008,236 from a non-recourse loan from Hollandsche Bank-Unie N.V. ("HBU"). HBU was a wholly owned subsidiary of ABNAMBRO Bank N.V. ("ABN").
  • On June 30, 1997, ABN, on behalf of HBU, transferred $68,008,236 (the funds representing the HBU loan) into BB&T's Trust (the "Trust") account at ABN.  BB&T transferred $18,228,895 into the Trust account at ABN. Thus, at closing a total of $86,237,131 was deposited into the Trust account at ABN either by BB&T or on BB&T's behalf.
  • Sodra was required to pay $68,008,236 to ABN as "Debt PUA Issuer" under the Debt Payment Undertaking Agreement ("Debt PUA"). Under the Debt PUA, BN was obligated to make certain payments to BB&T on Sodra's behalf.
  • Sodra was required to pay $12,000,193 to Fleet National Bank ("Fleet") as the "Equity PUA Issuer" under the Equity Payment Undertaking Agreement ("Equity PUA"). Under the Equity PUA, Fleet was required to use the $12,000,193 to purchase certain government securities.

Sodra's Debt PUA and Equity PUA payments were made at closing as follows: (1) the Trust, on Sodra's behalf, made the $68,008,236 payment that Sodra was required to make to ABN as Debt PUA Issuer using proceeds of BB&T's first installment payment and (2), the Trust, on Sodra's behalf, made the $12,000,193 payment Sodra was required to make to the Equity PUA Issuer also using proceeds of BB&T's first installment payment. In sum, $86,237,131 was deposited into the Trust account at ABN either by BB&T or on BB&T's behalf. Of the total deposited by BB&T, $80,008,429 was paid on Sodra's behalf to the Equity PUA the Debt PUA, leaving a balance of $6,228,702, which the Trust transferred to Sodra's account at ABN. BB&T has described this $6 million payment as Sodra's "incentive for doing the deal."

Pursuant to the Lease, Sodra was required to make annual rent payments to BB&T. Sodra's rent payments were equal to BB&T's scheduled loan payments to HBU, in both amount and timing, through January 1, 2012. In addition, BB&T's scheduled debt payments to HBU on the HBU loan, and Sodra's annual rent payments to BB&T, were equal to the scheduled payments required by the Debt PUA, which obligated ABN to pay Sodra's rent during the Head Lease term directly to HBU, until January 1, 2012. The interest rate on the funds that Sodra paid to the Debt PUA Issuer was equal to the interest rate on the HBU loan. Thus, the Debt PUA payments from ABN to its subsidiary HBU satisfied both Sodra's rental obligations to BB&T under the sublease and BB&T's obligations to HBU under the loan agreement. Finally, the Debt PUA obligated ABN to make a final payment of $11,542,500 in 2013, either to or for the benefit of Sodra, depending on which of the options at the end of the Lease are exercised by the parties.

Net effect: Sodra received a $6 million dollar payment and continued to use the property the same before/after the transaction; ABN received $6,228,702 for its participation and Fleet was holding on to $12,000,193 which has been invested in government securities for someone’s benefit; and BB&T received the rental/lease and interest deductions, while having to report rental income.

HOLDING:

The Court stated that the parties agreed that the applicable doctrine was substance over form and cited to Frank Lyon Co. v. United States, 435 U.S. 561, 572 - 73 (1978). The Court then found that if BB&T wanted the rental deductions the facts had to establish that it had an interest in the property. Citing and analyzing the facts in Alstores Realty Corp. v. Comm'r, 46 T.C. 363, 371 (1966), the Court found that Sodra's use and possession of the Equipment was unaltered by the Transaction (but for BB&T's annual right of inspection). In particular, Sodra used, maintained, and serviced the Equipment as it did before the Transaction and even made significant investments in and improvements to the Equipment. In addition, Sodra was entitled to all of the profits generated from the use of the Equipment during the term of the Lease. Moreover, although the form of the transaction required Sodra to make rent payments to BB&T, those payments were in fact made by the Debt PUA, were funded in full by BB&T's Initial Head Lease Payment, and did not require Sodra to invest any of its own funds. Thus, the Court found that only a future interest in the property was conveyed to BB&T.

BB&T asserted that it bore an unlimited risk of loss in the vent certain options were not exercised. The Court found the Transaction was structured so that there was no risk to BB&T's initial (and only) cash outlay. Of the $18,228,895 million that BB&T initially transferred into the Trust account at ABN, $12,000,193 was paid to the Equity PUA to purchase certain government securities. The remainder of BB&T's equity investment, $6,228,702, was transferred to Sodra's account at ABN as Sodra's "incentive for doing the deal." In the event Sodra exercised the purchase option, the funds in the Equity PUA would be returned to BB&T through the payment of the purchase price. In the event Sodra did not exercise the purchase option and BB&T enforced the Sublease Renewal provision, the funds in the Equity PUA would be returned to BB&T through the Sublease Renewal rents. Moreover, BB&T's own internal documents noted that Sodra's Letter of Credit requirement added to BB&T's security that its initial investment, and anticipated after- tax yield, would be protected from the loss at all times.

The Court finally held that when the intermediate payment steps were disregarded, which must be done in order to consider the substance of the loan transaction and not the form selected by the parties, it became clear that the loan transaction was only a circular transfer of funds in which the HBU loan was paid from the proceeds of the loan itself. There was no money lent to BB&T in a substantive sense, and the HBU loan did not reflect genuine indebtedness.  The Court stated:

"For interest to accrue there must be an underlying indebtedness requiring an "unconditional and legally enforceable obligation for the payment of money." Autenreith v. Comm'r, 115 F.2d 856, 858 (3d Cir.1940), aff'g 41 B.T.A. 319 (1940). In this case, although the loan documents -- the form selected by the parties -- may provide that BB&T had a legal obligation to repay the loan, the transaction in fact -- the substance -- did not actually require BB&T to pay any money to HBU. Through the circular nature of the transaction, BB&T's purported principal and interest payments were actually paid from the proceeds of the loan itself. In fact, after the closing in June 1997, BB&T was not required to provide any additional funds over the life of the loan. As such, BB&T's purported interest payments could not be what Congress intended to allow as an income tax deduction. "

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.