Fifth Circuit Decides Klamath on Economic Substance for Tax Shelters

The Fifth Circuit has rendered its long-awaited decision in Klamath Strategic Investment Fund v. United States, ___ F.3d ___ (5th Cir. 2009). By way of background, Klamath involved the BLIPS tax shelter that was involved in the star-crossed KPMG individual defendants criminal indictment way back in 2004 (as well as the related KPMG deferred prosecution agreement). After slapping the Government for prosecutorial abuse in that case and dismissing most of the defendants (dismissal sustained in United States v. Stein, 541 F.3d 130 (2d Cir. 2008)), the Government finally took four of the defendants to trial and obtained a conviction on the BLIPS shelters in December 2008. During the winding journey that started at least by 2004 and ended in those convictions in December 2008, the Government had pulled out all the stops to prevent the issue of viability of the BLIPS shelter from being decided in a civil case. Obviously, the reason was that, if a taxpayer prevailed in a civil case or even avoided penalties in a civil case, the Government's charges in the criminal case might not pass the requirement that the legal duty be certain in order to support criminal charges (as established by the Supreme Court in James and in a number of cases from the courts of appeals, including Garber (5th Circuit), Dahlstrom (9th Circuit) and Pirro (2d Circuit).

Notwithstanding the Government's determined attempt to avoid a civil test of its claims about BLIPS, the district court in Klamath refused to stay the case and took it to resolution, hence the court of appeals case. In the district court, the court made a critical pre-trial ruling sustaining the legal superstructure employed in BLIPS (and many other tax shelters) which centered on an application of the Helmer case to allow, in effect, a cost-free basis in a partnership interest from a conditional obligation. At trial, however, the court held that (1) notwithstanding its previous holding that Helmer works (or at least worked at the time the shelter was implemented), the BLIPS transaction in the case failed the economic substance test and thus the IRS adjustments at the partnership level were correct but (2) (a) the accuracy related penalty did not apply and (b) in any event, partnership established the defense of reasonable cause and good faith defense precluded the IRS's claim for the accuracy related penalties. The partnership appealed the first holding (on the economic substance test), and the Government appealed the holdings on (1) that the penalty did not apply and (2) the predicate holding that the Helmer gambit in the case worked.
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