Further Comments on the Briefing in the Larson, Pfaff and Ruble Cert Petitions (6/21/11)

I have just received the Government's Brief in Opposition to Certiorari in the Larson and Pfaff cases (Sup. Ct. Dkt No. 10-1049) and Brief in Opposition to Certiorar in the Ruble Case (Sup. Ct. Dkt No. 10-1061). I have previously blogged on the Petitions for Certiorai in those cases in the following blog entries: Petitions for Cert in US v. Pfaff, Ruble & Larson and The Conduct Too Remote Is Not Evasion Argument in the Larson & Pfaff Petition for Certiorari . I have just a few points that I wish to make on the documents documents I just received:

1. The issue that I think is worthy of certiorari is whether the economic substance doctrine draws a sufficiently knowable criminal line. (I have previously blogged on facets of this issue here.)  The problem, in my mind, is that the Supreme Court itself has botched the analysis and approved civilly transactions that lack economic substance relative to the taxpayer's participation in the shelters / arrangements. Charles Kingson, are respected observer in this area, has said pungently:
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More on the Daugerdas Case - The Role of Nonpromoter Enablers (6/5/11)

The Chicago Tribune reports on the consequences of BDO Seidman's love affair with the Daugerdas shelters. See Ameet Sachdev, Tax shelters put BDO Seidman in middle of firestorm with federal prosecutors, Chicago Tribune, Business (6/4/11). It is interesting to consider what additional retribution, if any, the Government may visit on BDO now that its former chief executive, Denis Field, has been convicted and others down the BDO food chain have pled. For all of the firms participating in this genre of shelters, one has to ask where the gatekeeper was or the gatekeepers were. Was anyone concerned about the well-being of the firm?

Someone has asked that question about Jenkens & Gilchrist, the Dallas based firm with national ambitions that drove it to expand, inter alia, into Chicago and pick up the now disgraced and convicted tax shelter promoter par excellence, Paul Daugerdas. I have written about Daugerdas before and want to discuss here a variation of the Jenkens & Gilchrist story recounted in a recent article, Milton C. Regan, Jr., Taxes and Death: The Rise and Demise of an American Law Firm, STUDIES IN LAW, POLITICS AND SOCIETY: LAW FIRMS, LEGAL CULTURE, AND LEGAL PRACTICE, Vol. 52, pp. 107-144, Austin Sarat, ed., JAI Press 2010; Georgetown Law and Economics Research Paper No. 11-08.
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Economic Substance Doctrine Tax Felonies (6/1/11)

I write today to provide viewers access to Jasper Cummings' article, Jasper L. Cummings, Jr., Economic Substance Doctrine Felonies, 131 Tax Notes 977 (May 30, 2011) and 2011 TNT 104-10 (5/31/11). (This article is provided with the permission of Tax Analysts.)  Mr. Cummings writes on the use of the economic substance doctrine in criminal tax cases. Most particularly, he writes about Mr. R. J. Ruble who was convicted in the first round of Son-of-Boss criminal prosecutions. In that case, Ruble, a tax lawyer, was convicted along with John Larson and Bob Pfaff who provided financial services in the conceptualization and implementation of the shelters. Two prominent subsequent shelter prosecutions have also used the economic substance doctrine in the charges to the jury.

First, let me disclose that I represented one of the dismissed defendants in the sprawling prosecution that ended up in the conviction of Messrs. Ruble, Larson and Pfaff. Once my client was dismissed along with 12 others before trial, I no longer had an immediate interest in the case but I did observe the progress of the proceedings through conviction and appeal and now pending petition for certiorari in the Supreme Court. I was particularly interested in whether and how the economic substance doctrine would be presented to the jury.
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Petitions for Cert in US v. Pfaff, Ruble & Larson

Petitions for certiorari have been filed in the criminal convictions of John Larson, Robert Pfaff and R.J. Ruble in the massive KPMG-related criminal case which drew fame in an earlier iteration (United States v. Stein before 13 defendants were dismissed for prosecutorial abuse). The Second Circuit summary affirmance of the convictions of Larson, Pfaff and Ruble is here. The petition for John Larson and Robert Pfaff is here. The petition for R. J. Ruble is here..
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Another Set Back for the Remaining Daugerdas Defendants - Economic Substance is Sufficiently Malleable to Establish a Line a Citizen Could Know

Judge Pauley, USDC SDNY, served up a loss for the Daugerdas defendants just before Christmas. The opinion in United States v. Daugerdas, 759 F. Supp. 2d 461 (SD NY 2010) is here. The defendants made the now standard argument in complex tax shelters, particularly those based on extrapolations of Helmer, that, given Helmer, the law was not sufficiently clear to establish a legal duty that the defendants could know. I have previously blogged on facets of this issue before. See here.

As occurs frequently, Judge Pauley conflates two distinct -- albeit related -- concepts. The threshold issue is whether the duty was knowable -- a legal inquiry that is separate from what the defendants might have known or intended. James and its progeny establish that the duty must be sufficiently clear that a citizen (not necessarily the actual defendant in the dock) could know the duty. Only if that question is answered in the affirmative is the Cheek issue reached -- did the defendant know the knowable legal duty? That is an issue for the jury to determine after trial so long as the prosecutors have enough evidence to survive a motion for acquittal.

Without citing James or its progeny, Judge Pauley does address the James threshold issue. Bottom line, he holds that the economic interest concept as a bar to claimed benefits and as interpreted by the courts (it is a judicial doctrine, after all) was sufficiently certain to give the hypothetical citizen a line that could be crossed (aka was knowable), leaving the issue for trial of whether these particular defendants knew the line they allegedly crossed. Could have known is not sufficient for a criminal conviction. The Government will have to prove that the did know. But that is another chapter.

Justice Stevens Announces Retirement

The papers announce today Justice John Paul Stevens' long expected retirement. He is a great judge and will be missed on the Supreme Court and throughout the country. 

I had first encountered Judge Stevens in arguments in the 7th Circuit Court of Appeals long ago.  I found him exceptionally sharp and willing to mix it up intellectually.  I eschew war stories here, however interesting they may be to me.  Being a tax lawyer and being concerned about the development of the tax law for the good of society as a whole, I can point to one particular matter in which his voice, spoken in dissent, should have been heeded.  That was in Frank Lyon Co. v. United States, 435 U.S. 561 (1978), a case that, in my opinion (I am not alone) was wrongly decided by the majority and has had disastrous consequences to the orderly development of the tax law over the years.  Therefore, I quote Judge Stevens' dissent in Frank Lyon in its entirety.  Although it would help to have read the majority opinion to knew the target he is shooting at, it is not critical.  If you have been more than casually involved in or observing the tax shelter industry over the years, you will understand why he is right:  The doctrine of economic substance developed on the shoulders of his dissent would have been a lot more coherent.
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Altria #2 - Economic Substance and Juries (3/22/10)

In Altria (see blog here for introduction), Judge Holwell submitted the issues to the jury as follows:

The Court instructed the jury to analyze the transactions under the two common law disallowance methods relied on by the Government: the "substance over form" doctrine, and the "economic substance" doctrine. With respect to substance-over-form, the Court instructed the jury to put aside the labels used or names given to the documents and transactions, and decide whether Altria actually acquired and retained a genuine ownership interest in the Seminole, Oglethorpe, and Vallei facilities, and a genuine leasehold interest in the MTA facility. The jury was to consider "all the relevant facts and circumstances surrounding the transactions," including eight non-exclusive factors identified by the Court. 4 (Charge to the Jury, at 33-34 (Docket No. 146).) At the same time, the Court cautioned the jury that its analysis should turn on the facts as it found them, including its understanding of how the transactions were designed to unfold: "You must consider and give the appropriate weight to all the relevant facts and circumstances. In the end, the question is whether Altria retained significant and genuine attributes of traditional owner (or lessor) status." (Id. at 34.)

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Economic Substance Jury Instruction in Larson/Pfaff/Ruble

I previously attached deep in a blog Judge Kaplan’s economic substance charge to the jury in United States v. Larson (S.D. N.Y. No. 05 CR 888 (LAK)), dated 12/11/08, pp. 5225- 5232.  I have decided that, because of the ongoing discussion I should lift it up into a separate blog for those who might have missed it.

In order to prove that element in this case, we focus on the doctrine of economic substance. In this case, the government contends that the taxpayers whose tax returns are the subject of each count of tax evasion, owed more federal income tax then they reported on the returns for one reason only, in each case the taxpayer took a deduction from his taxable income due to a loss that the tax return attributed to one of the four tax strategies at issue in this case. You remember them, FLIP, OPIS, BLIPS and SOS.

The government argues that every one of those tax strategies lacked economic substance. That the tax deduction each one of those taxpayers took was improper, for that reason, and, therefore, that each taxpayer owed more federal income tax than was declared on the tax return. The defendants dispute that. They contend, among other things, that the tax strategies did not lack economic substance, that the deductions were proper, and that the tax returns, therefore, accurately stated the amounts of tax that were due and owing.

This means that your task here, with respect to the first element, is to decide for each count, whether the tax strategy that gave rise to the loss claimed as a deduction on that tax return, lacked economic substance in order to decide whether the relevant taxpayer owed more federal tax, income tax, than was shown that was due on the tax return. So I am now going to instruct you with respect to your consideration of the economic substance issue.

A transaction that lacks economic substance cannot enter into tax computations. Any deduction claimed for a tax loss that allegedly was sustained in such a transaction, therefore, is not properly claimed on a tax return.

In order to establish that a transaction lacks economic substance, the government must prove beyond a reasonable doubt both of two factors. The first factor is that the relevant taxpayer had no business purpose for engaging in the transaction apart from creating the tax deduction.

The second factor is that there was no reasonable possibility that the transaction would result in a profit.

Now, let me define one term and say a few things about each one of these factors.

First the definition. The word profit, as I use it in this context, means a return in excess of the cost of the investment, disregarding entirely any tax benefits. Let me give you an example. If somebody puts a million dollars into a deal, he would have to get a return of more than a million dollars without considering any tax benefits in order for the transaction to be profitable. Common sense. A return of $750,000 on a million dollar investment results in a loss of $250,000, not a profit. That's what I mean by profit. Forget the tax benefits, look at the investment and the return.

Now, let me discuss the first element that I mentioned, whether the taxpayer had any business purpose for entering into the deal. In deciding that question, you, of course, may consider any direct evidence of the taxpayer's motive. But you are not limited to direct evidence in deciding why a taxpayer did a transaction. You can consider circumstantial evidence as well.

I am going to talk to you later about what circumstantial evidence means. But for purposes of the present, think of it just as common sense, and then I will explain it later on.

For example, you may consider the manner in which the transaction was sold to the taxpayer. In other words, you are entitled to consider whether and to what extent it was sold to the taxpayer as a way to create a tax deduction to offset other taxable income, and/or as a way to generate a return, a profit, exclusive of tax benefits on the investment. You are entitled to consider that.

You may consider also whether a reasonable taxpayer would have paid the fees necessary to do the transaction in order to gain the chance of whatever profit potential existed if the transaction did not also carry with it tax benefits.

Now, let me try to put this into plain English. What helped me think about it, maybe it will help you, I am going to give you a couple of examples, so bear with me on the examples. Let's take an example in which a taxpayer has to put up $2 million to enter into some deal or strategy. Suppose further that the strategy in question offers a five percent chance, that's one chance out of 20, resulting in a payout, when all is said and done of $2,050,000. In other words, it's a one in 20 chance of making $50,000 on a $2 million investment.

Assume also that the taxpayer has a huge amount of income, and that there is a very big tax benefit to the strategy, maybe a $10 million tax loss or deduction.

Now, common sense will tell you that few, if any, people, no matter how rich they are, would put up $2 million for a five percent chance, a one out of 20 chance, of making $50,000. So on those facts you might conclude that there must have been only one reason for the taxpayer to have paid the $2 million. And that the $10 million tax loss or deduction probably was the only reason.

Let me give you another example, also an example in which the same taxpayer has to put up the same $2 million.

What's different in this example is this, assume there is a 33 percent chance, now it's one out of three we are talking about, of getting a payout of $3 million. And thus a profit of a million dollars within a year. Now, a 33 percent chance, a one out of three chance of making a profit, is not bad odds, it's pretty good odds. And a million dollars is nothing to sneeze at, even if you are very rich.

In this second example, the high likelihood, relatively high likelihood, and the large size of the potential profit, would be circumstances that might tend to show that the taxpayer had a nontax reason for doing the deal.

Many people might consider it a very good investment opportunity, without regard whether there was any tax benefit.

In the end, what you would do, is to consider all the evidence, direct, if there is any, and circumstantial, to decide whether the government had proved that the tax benefits were the only reason for doing the deal.

Those are my examples.

So let me come back to this case. If you find that the government has proved that the tax benefits were the only reason for doing the deal involved in any particular count, you will go on to consider the second part of the economic substance test that I gave you a moment ago. And that I am going to talk about more in a minute.

If you find, however, that the government has not proved that the tax benefits were the only reason for doing the deal, you must reject the government's economic substance argument. And you, therefore, must reject its contention that there was additional tax due and owing. That in turn would require you to find the defendant or defendants in question, not guilty on the particular tax evasion count that related to the particular taxpayer and year in question.

Now, let me say a word about the second fact in the economic substance test, which is whether there was a reasonable possibility that the strategy involved on the count you are considering would result in a profit.

Now, at one level this is largely self-explanatory, but I want to emphasize to you that this factor requires you to come to an objective judgment about whether the government has proved that there was no reasonable possibility that the strategy would result in a profit. In other words, this doesn't depend on what the taxpayer believed about the tax potential -- excuse me, the profit potential -- it requires you to consider all the evidence that you have, and reach a conclusion about whether the government has proved beyond a reasonable doubt, that there was no reasonable possibility of a profit.

In doing this, you are going to have to consider the evidence concerning investment aspects of each of the four tax strategies at issue in this case. For example, the transactions involving the Argentine peso and the Hong Kong dollar that were involved in the BLIPS strategy, and the foreign currency options that were involved in the SOS strategy. Of course, you have to consider the particulars of the other two strategies, as well, I mentioned those because they come immediately to mind.

Now, in considering whether the government has met its burden on the second factor, you should take into account whether the taxpayer, considering all the aspects of the strategy, had any reasonable chance of making a profit or suffering a loss as a result of changes in the market.

To take one example, if you are considering a BLIPS deal, you should consider whether the taxpayer had any reasonable chance of making a profit or suffering a loss as a result of changes in the value of the Argentine peso and the Hong Kong dollar, given the terms of the deal. If you find that the government has proved beyond a reasonable doubt both prongs of the economic substance test, in other words, both that the taxpayer had no nontax reason for doing the deals on the count in question, and that there was no reasonable possibility of making a profit, you may find that the requirement of additional tax due and owing will have been satisfied, and you will go on to consider whether the government has proved that the additional tax due and owing was substantial.

Altria # 1 - Frank Lyon and tax shelters (3/20/10)

I write today about a decision in a refund suit because it involves a jury verdict in a highly structured tax shelter. I have spent some words in this blog discussing concerns about the task a criminal jury faces in determining criminal liability for structured tax shelters, so I think this case is notable for this blog. In Altria Group, Inc. v. United States, 2010 U.S. Dist. LEXIS 25160 (S.D.N.Y. 2010), the jury was tasked to determine whether the substance over form or the economic substance doctrines (or both) applied to deny the taxpayer the tax benefits of ownership.

As introduction to the case and today's topic, I quote Judge Holwell's introductory summary of the case:

This case concerns federal income tax deductions plaintiff Altria Group Inc. and its subsidiary Phillip Morris Capital Corp. ("PMCC" or "Altria, " collectively with plaintiff) generated by leasing big pieces of infrastructure from tax-indifferent counterparties. These tax shelter transactions are known in the leasing industry as SILOs ("Sale-In-Lease-Out") and LILOs ("Lease-In-Lease-Out"). Following a two-week trial, the jury concluded on the facts presented to it that plaintiff's SILOs and LILOs lacked economic substance and failed to transfer tax ownership of the properties to Altria, thereby justifying disallowance by the IRS of certain deductions claimed by Altria. Several courts and another jury have reached similar conclusions in other jurisdictions. See BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008); AWG Leasing Trust v. United States, 592 F. Supp. 2d 953 (N.D. Ohio 2008); Fifth Third Bancorp & Subs. v. United States, 05 Civ. 350 (S.D. Ohio, April 18, 2008) (jury verdict); Wells Fargo & Co. v. United States, 91 Fed. Cl. 35 (Fed. Cl. 2010). But see Consolidated Edison Co. v. United States, 90 Fed. Cl. 228 (Fed. Cl. 2009).

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More on Economic Substance in Criminal Tax Cases - the Coplan Instructions.

I have previously blogged on the application of the economic substance doctrine in criminal cases. I offer in this blog the application of the economic substance doctrine in the jury instructions in United States v. Coplan (SD NY No. (S1) 07 Cr. 453 (SHS)). Coplan was the E&Y-related criminal case and, in respect to economic substance, involved the same range of issues and problems as the KPMG-related criminal case on which I have previously blogged. (The entire set of jury instructions here; I shall quote the parts I believe most relevant below.)

The economic substance instruction in Coplan came as a subset of the instruction on the Tax Due element for tax evasion. The Court instructed the jury that the Government was required to prove that there was "a substantial amount of due." (Instr. p. 42.) This is a pretty straight-forward instruction.

Before moving to economic substance, I comment briefly on the task the jury is asked to perform in determining tax due in complex tax cases, including tax shelter cases. These shelters are usually very complex. When they are litigated in a civil context by the taxpayer who actually may owe the taxes, the litigation usually produces a lengthy opinion from a trained judge making many findings of fact and applying sometimes arcane principles of tax law in coming to a conclusion that the shelter works or doesn't work (usually doesn't work in this type of aggressive shelter). The jury by its general verdict of guilt or innocence just cuts to the chase on that issue (and the other elements of the crime(s) charged) without having to be bothered with a detailed analysis to support the conclusion. At least with detailed findings of fact and conclusions of law, the judge has been forced to go through the rigorous steps from a to z and appellate courts and the public can determine whether the conclusion is good. With general verdicts of guilty or not guilty, we cannot test the jury's rationale. But that is the nature of the general jury verdict, so I move on.

The Court then treated the economic substance doctrine as being the central determinant of whether there was a tax due and owing. In other words, most of these shelters had other, more tax-geeky problems that were potentially fatal, but the trial centered around the alleged economic substance defect and that was the instruction that was given. I quote now the relevant instructions (pp. 43 - 48).

The government contends with respect to Counts Two and Three that there was a tax due and owing because losses claimed as a result of the CDS Add-On tax shelter were not properly deductible under the tax laws, and thus that the clients understated the taxes they owed when those losses were reported on their tax returns as deductions that offset taxable income or gains. The government’s position is that the CDS Add-On shelter lacked economic substance.

This means that you must decide whether or not the CDS Add-On tax shelters implemented in Counts Two and Three lacked economic substance, and thus whether any of the relevant taxpayers claiming deductions from the shelter owed more federal income tax than was reflected on their individual tax returns.

* * * *

I will now instruct you on how to determine whether economic substance exists with respect to each relevant taxpayer.

Under our system of tax laws, a loss produced through a financial transaction that lacks economic substance cannot enter into a taxpayer’s tax computations. Any [*45] deduction claimed for a tax loss sustained in such a transaction cannot properly be claimed on a tax return. Thus, if you find that the tax losses from the CDS Add-On shelter were not properly deducted, you may conclude that the taxpayers owed more in taxes than was reported on their income tax returns, and proceed to decide whether that amount was substantial.

In order to establish that a transaction lacks economic substance, the government must prove two elements beyond a reasonable doubt:

The first element is that there was no reasonable possibility that the transaction would result in a “profit.”

The second element is that the relevant taxpayer had no business purpose for engaging in the transaction in question apart from the creation of the tax deduction.

Now, let me define a term and then say a few things about each of these elements.

First the definition. The word “profit” in this context means a return in excess of all the fees and costs incurred by the client in connection with entering into the tax shelter, disregarding entirely the value of any tax benefits.

Now let me say a few words about your determination whether there was a reasonable possibility that the shelter would result in a profit. This element requires you to reach an objective judgment about whether the government has proved that there was no reasonable possibility that the shelter would result in a profit. In other words, this does not depend upon what the taxpayer believed about the profit potential. It requires you to consider all of the evidence and reach a conclusion about whether the government has proved beyond a reasonable doubt that there was no reasonable possibility of a profit on the tax shelter after the fees and other costs were paid. If you find that the government [*46] has proved beyond a reasonable doubt that there was no reasonable possibility of a profit, then you move on to the second element, whether the relevant taxpayer had no business purpose for engaging in the tax shelter. If you find that the government has not proved the lack of a reasonable possibility of a profit, then you must reject the government’s theory and find the defendants not guilty.

Now let me discuss the second element that I mentioned—whether the taxpayer had any business purpose, that is, a non-tax reason, for participating in the shelter. In deciding that question, you may consider any direct evidence of the taxpayer’s motive. For instance, you may consider testimony or other statements by the taxpayer as to his or her reason or reasons for participating in the shelter.

But you are not limited to direct evidence in deciding why a taxpayer participated in the shelter. You may consider circumstantial evidence as well. For example, you may consider the manner in which the shelter was marketed or sold to the taxpayer. Thus, for instance, you are entitled to consider whether and to what it extent the shelter was advertised as a tax savings device, a means of obtaining a profit, and so forth. You may also consider the likelihood of a significant profit in relation to the amount of fees that clients were required to pay to participate in the tax shelter. Common sense tells you that if the client pays large fees to enter into a transaction with a large intended tax benefit and a very small likelihood of profit, that fact might tend to show that the client did not have a non-tax reason for doing the shelter. Conversely, if there is a significant possibility that the transaction will return a profit greater than all fees and costs, such a fact might tend to show that the client did have a non-tax reason for doing the transaction.

Taking into account both direct and circumstantial evidence of the relevant taxpayer’s intent, you must determine whether the government has proved beyond a reasonable doubt that the relevant taxpayer had no business or non-tax reason for doing the tax shelter in order to conclude that it lacked economic substance.

If you unanimously find with respect to at least one relevant taxpayer in each of Counts Two and Three that the government has proved beyond a reasonable doubt both prongs of the economic substance test—that is, losses were claimed on an individual tax return as a result of a tax shelter for which there was no reasonable possibility of making a profit and where the relevant taxpayer had no business purpose for engaging in the shelter—you may find that the requirement of additional tax due and owing is satisfied with respect to the count you are considering. * * * *

However, if you do not find that both elements of the economic substance test have been proven beyond a reasonable doubt as to losses claimed by any relevant taxpayer in a given count, then the government will not have proved that additional tax was due and owing as to that count, and you must find the defendants not guilty of the tax evasion count you are considering.

Well, that's it. The court invites the jury to consider indirect evidence as to the "relevant taxpayer's" purpose in participating in the shelter. This is a wholly subjective inquiry as to the relevant taxpayers. Since, I speculate here, these taxpayers made representations that they had such an independent profit motive, the jury must have concluded that those "relevant taxpayers" lied in making the representation and, therefore, that they too were guilty of tax evasion. Now tax evasion in such circumstances in criminal trials against the taxpayers is usually proved by circumstantial evidence since the taxpayer usually does not testify and, in any event, there is no direct proof of the mental state of mind required. But, I suspect that in these cases, the criminal jury is sorely tempted to conflate the two economic substance prongs -- we the jury find that there is no reasonable possibility of profit and therefore the taxpayer cannot have reasonably had a profit motive and therefore he or she did not have a profit motive. I just wonder if the jury actually has enough evidence to make the latter conclusion without the erroneous intervening logical step. In other words, there is no requirement in the economic substance test that the taxpayer's profit motive be reasonable or correct; just that the taxpayer have the profit motive. To give the jury the tools / record to get properly to the conclusion, the Government would have had to prove up a separate evasion case against each of the "relevant taxpayers." My suspicion / speculation is that the Government did not do that and left the jury to speculate that the taxpayers did not have the required profit motive because, in the jury's collective mind, no reasonable taxpayer could have the required profit motive.

And this does not even address what a reasonable profit motive even is.

More on Economic Substance in Criminal Tax Cases

I have previously blogged here on the stunning not guilty verdict in the Virgin Island’s residency issue. I thought I would share excerpts from the jury instructions in the case. (Thanks to Chuck Meadows, a lead defense lawyer in the case, for provising them.)  The portion related to the tax crimes allegations may be viewed here. I provide below a subset of those excerpts dealing with the economic substance / sham transaction issue. My question to readers is whether these instructions give a jury meaningful guidance on the economic substance issue? The court equates lack of economic substance and sham transaction which I think is defendant friendly because, I believe, lack of economic substance as the Government imagines it in criminal cases is a broader concept than sham transaction.

[*41]

Sham Transactions

101. The third way in which the government seeks to satisfy the first element of income tax evasion, that is, that Mr. Auffenberg claimed false deductions against his income, is based on the legal principle that for transactions to be recognized for tax purposes, they must have economic substance. In other words, even if a transaction complies precisely with all requirements of the Internal Revenue Code for obtaining a deduction, if it lacks economic substance it simply is not recognized for federal taxation purposes.

102. The taxpayer has a legal right to decrease the amount of what otherwise would be his taxes or altogether to avoid them, by means which the law permits. However, the first of two critical questions is whether what was done, apart from the tax benefits, was the thing which the law intended. If it was not, you must then answer the second question, which is whether the defendant willfully engaged in such conduct for the purposes of evading taxes. I will explain the concept of "willfulness" to you momentarily.

103. In determining whether a particular transaction is a "sham," that is, whether it lacked economic substance, you are instructed to consider the overall circumstances surrounding the asserted transaction. Furthermore, when presented with a series of related transactions, the income tax effect of these [*42] transactions can only be evaluated by viewing the series of related transactions in their totality. It is the economic reality behind a series of interrelated steps viewed as a whole that matters.

* * * *

" Willfully"

108. For the counts of income tax evasion, conspiracy to defraud the United States, and other specific counts set forth in these instructions, the government must prove beyond a reasonable doubt that each defendant acted willfully. For you to find that a defendant acted "willfully, you must find that he voluntarily and intentionally violated a known legal duty under the tax laws.

[*45]

"Good Faith

109. The defendant's conduct was not willful if he acted through negligence, mistake, accident, or due to a good faith misunderstanding of the requirements of the law. A person acts in "good faith" when he or she has an honestly held belief, opinion, or understanding regarding the law, even though the belief, opinion, or understanding turns out to be inaccurate or incorrect. Thus, in this case if a defendant made an honest mistake or had an honest misunderstanding about the law, he did not act willfully.

Note that this instruction does not include the broader spin on economic substance given by Judge Kaplan in the Larson case involving the KPMG tax shelters. That spin was:

In order to establish that a transaction lacks economic substance, the government must prove beyond a reasonable doubt both of two factors. The first factor is that the relevant taxpayer had no business purpose for engaging in the transaction apart from creating the tax deduction.

The second factor is that there was no reasonable possibility that the transaction would result in a profit.

For Judge Kaplan's further elaboration on what this means, see his excerpted jury instructions here.

The KPMG Enabler Convictions -- The Role of the Absent Taxpayers

In the Larson/Pfaff/Ruble case, currently on appeal to the 2d Circuit, the trial Judge instructed the jury:

In order to establish that a transaction lacks economic substance, the government must prove beyond a reasonable doubt both of two factors. The first factor is that the relevant taxpayer had no business purpose for engaging in the transaction apart from creating the tax deduction. The second factor is that there was no reasonable possibility that the transaction would result in a profit.

(See here for the complete instruction.)

I want to focus again on the first element -- the proof beyond a reasonable doubt that the relevant taxpayer had no business purpose for engaging in the transaction apart from creating the tax deduction. (I refer in this blog to this purpose as just business purpose without repeating the formulaic words "apart from the tax deduction.") That instruction, in effect, tells the jury that the jury can convict the indicted enabler defendants of tax evasion if -- and only if -- the jury finds that the unindicted taxpayers were also guilty of tax evasion.

To some, that statement may not seem inevitable. Why can the enabler defendants in the case be convicted only if the unindicted taxpayers were guilty of tax evasion? Well, first off, no one could be convicted of tax evasion unless there is a tax due and owing. I have addressed concerns about tax due and owing in the case before, but I accept that, for purposes of this blog, the Government proved tax due and owing so as to be able to convict the indicted enablers for tax evasion. I now focus on the economic substance charge given above -- that the Government prove beyond a reasonable doubt that the taxpayers involved had no business purpose. Each of those taxpayers represented that they had such a business purpose. So, if the jury could make the finding that each of the taxpayers did not in fact have such a business purpose, they necessarily had to find beyond a reasonable doubt that they had committed tax evasion. They may not have brought back a guilty verdict against those taxpayers (who were not and never have been charged) but that is the inevitable conclusion of the jury's verdict under the instructions given by Judge Kaplan.

The question I now ask is whether the Government really proved a tax evasion case against each of those taxpayers as a necessary, but unstated, requirement to make the finding of guilt of tax evasion against the indicted enablers. I have previously suggested that, at least for some of the counts of conviction for evasion, the Government showed precious little about the subjective intent of the taxpayers and, in fact, only showed that, perhaps, a reasonable taxpayer could have had the intent.

One can fight over the fair inferences from the proof at that particular trial, but I ask you to assume with me now that the gravamen of the proof was as follows: (i) the underlying investment play wrapped into the BLIPS program was such that there was no objectively reasonable possibility of profit (let's not fight either about what reasonable is, or is is for that matter), so that it is fair to infer that a reasonable business-purpose motivated taxpayer would not enter the deal; (ii) Taxpayer B entered into the deal; (iii) Taxpayer B had a lot of income that was sheltered by the deal; (iv) Taxpayer B was a very successful businessman, at least in terms of his ability to earn lots of income as reflected on his returns; and (v) Taxpayer B represented in the deal documents that he did have a subjective business purpose apart from the tax benefit.

I think the question no those bare assumptions is whether there is a criminal jury issue on Taxpayer B's subjective business purpose. Stated otherwise, the question is whether there is sufficient evidence that a reasonable jury could find beyond a reasonable doubt that Taxpayer B did not have the subjective business purpose he represented he had in the deal documents. I think on the bare facts I have posited, the evidence would not be sufficient.

This point can best be made by adding an additional assumed fact -- that it is Taxpayer B who is charged with evasion.  I suggest that tax evasion trials require a whole lot more essential background and proof bearing upon the taxpayer's subjective intent before the jury is permitted to determine whether a taxpayer is guilty of tax evasion. Ultimately, the Government will have to prove that the taxpayer knowingly lied in making the business purpose representation, from which the jury could infer that he intentionally violated a known legal duty. And in order to do that the Government would have to make an individualized showing about the particular taxpayer involved, his education, his business savvy, his advisors on the deal, and other facts from which, in the context of a complete picture about that taxpayer, the jury could infer the lie and the corresponding intent to violate a known legal duty. If all the jury had was the spare facts I have assumed, I doubt that the case would survive a motion for acquittal.

Moreover, there is at least a risk of great unfairness to making an unindicted taxpayer's subjective motives essential to a conviction of other parties.  The indicted parties have little ability to mount an effective defense -- particularly as to charges of tax evasion which required a host of detailed knowledge and proof about a particular taxpayer's motivations.  The Government can get its view of the proof by hauling those unindicted taxpayers into proffer sessions and grand juries and otherwise browbeating them into submission with threat of prosecutions and even inducement -- ultimately promises or, wink-wink, suggestions of nonprosecution -- to admit their culpability and convict others based on the taxpayers' alleged subjective beliefs which might be very malleable with the right inducements / or threats.  The indicted parties, however, can provide no such inducements for the taxpayers' cooperation nor even effectively pursue any discovery from them to make a defense to the essential claim that the taxpayers, by lieing about their business purpose, committed tax evasion.
What do the readers of this blog think about these concerns?

More on Legal Uncertainty and, More Importantly, the Subjective Prong of the Economic Substance Test

I have previously discussed here the economic substance instruction that Judge Kaplan gave in the skinnied down KPMG trial that resulted convicted three defendants of multiple tax evasion crimes and is currently on appeal to the Second Circuit. I blogged about the Government’s outsized brief filed last Friday (see the brief here). My topic of focus was the effect of legal uncertainty in the law.

Today, I carry that discussion further in the context of the Government’s claims about the role of the economic substance doctrine in a criminal tax case. To set the stage, there clearly is some uncertainty in the civil cases about the economic substance doctrine. Two tests have been developed, which the Government calls (Br. 55) and most practitioners call a subjective prong and an objective prong. The subjective prong is whether the taxpayer engaging in the transaction had a nontax profit or business objective. Under this test, tax can be a consideration but the taxpayer must have an actual business or profit object or intent; further, there is no requirement that the taxpayer's objective be reasonable. The objective prong is whether the transaction has some – perhaps limited to some reasonable – possibility of profit. The major uncertainty from the civil cases is whether the tests are in the conjunctive or disjunctive. That is, whether a taxpayer desiring to sustain his claim of tax benefits must prove (i) both that he had the profit objective (however unreasonable) and that it was a reasonable profit or business objective or (ii) either of those prongs. (For tax coneheads (among whom I number myself), this objective / subjective inquiry, if indeed conjunctive, may be analogized to the relief from the substantial understatement penalty for tax shelter transactions if the taxpayer had a belief that the transaction will more likely prevail and the belief is objectively reasonable.) The courts in the civil cases are split on that conjunctive / disjunctive issue for the economic substance test.

To state the obvious, criminal cases are not civil cases and different policies are implicated that requires some role reversal. The criminal case asks whether the Government has proved beyond a reasonable doubt that the civil tax result is certain and was willfully violated. Accordingly, in instructing the jury, as he should in a criminal case, Judge Kaplan adopted the most defendant friendly version of the split – that is, he advised the jury that the Government had to both that there was no taxpayer profit or business objective and no reasonable profit or business objective. I have doubts about turning over the economic substance test under either formulation to a jury in a criminal case, but if it must be turned over (and Second Circuit authority says it must), I think Judge Kaplan made the right choice by requiring the conjunctive application of the test. (It is important at this stage to note that the Government argued to Judge Kaplan that the jury should be instructed in the disjunctive – i.e., the jury can convict if either (i) under the subjective prong, the Government proved beyond a reasonable doubt that the taxpayers involved had no profit or business motive, or (ii) under the objective prong, the Government proved beyond a reasonable doubt that there was no possibility – or, in the Government’s mind reasonable possibility -- of profit; that notion is just goofy in a criminal case, but I won't digress further here.)

I want to return shortly to the subjective prong that, in my view, was transformed in this case to an objective inquiry (although I will continue to call it the subjective prong in order to differentiate it from the subpart of the economic substance test that really is supposed to be objective). As to the objective prong, the parties dispute at length in their brief as to whether the possibility of profit is limited by the adjective “reasonable.” I think much of this discussion is semantics echoing Bill Clinton’s famous line – “It depends on what the meaning of the word 'is' is.” (In this semantical game, the Government easily sets up a strawman only to knock it down.) I don’t want to enter that fray right now, but I want to return and address the so-called subjective prong of the economic substance test as it played out in the case.

Let’s go back to the test. It is supposedly an inquiry into the subjective thinking of the taxpayer(s) involved. And, the test as formulated is not an objective test; so long as the taxpayer(s) involved had a subjective profit motive, regardless of how unreasonable it may have been, the tax shelter passes this leg of the economic substance test in a civil case.  Transforming this test to a criminal setting, the Government would have to prove that the taxpayer(s) involved in the counts of conviction had no actual intent -- even if the intent were unreasonable.

As I shall note, at best at least for the absent, nontestifying taxpayers in the counts of conviction, all the Government may have proved beyond a reasonable doubt was that it may have been unreasonable for them to have a profit or business motive, but that is not the same as prove beyond a reasonable doubt that they did not have the motive.

I have asked before how the Government can make that stringent level of proof, at least as to taxpayers as to whom there was no evidence other than the fact that they claimed benefits alleged in the counts of convictions. These taxpayers did not testify and the Government introduced no evidence going to their actual intent. Judge Kaplan and the jury were left to infer that the taxpayers had no such intent solely from the objective evidence of their involvement and the further proof that Government had proved objectively that the shelters could not produce a profit (or at least a reasonable prospect of producing a reasonable profit). The net result is that, in my mind, the court and the jury just conflated two separate tests and turned them into a single objective test -- if the shelter transaction is objectively unreasonable, the presumption is that the taxpayers acted as reasonable persons and thus did not have the intent. This was virtually an irrebutable presumption becuase the taxpayers had no practical ability to prove what the taxpayers might have intended or to otherwise attack the presumption thus raised by the Government in meeting the objective prong of the test.

I ask this simple question: would the proof adduced at trial as to the absent taxpayers have alone sufficed in criminal prosecution of those taxpayers to prove beyond a reasonable doubt that they had no profit or business motive? Does that evidence prove beyond a doubt that the taxpayers could not have been mistaken? In a criminal prosecution of the taxpayers themselves, the Government would have proved a host of facts about the individual taxpayers (education, business savvy, etc.) that would have offered some basis to reasonably infer whether the taxpayers had the actual intent, however unreasonable, or not. At best, all the evidence proves -- perhaps even proves beyond a reasonable doubt -- is that a reasonable taxpayer would have had no such subjective profit motive. The test, however, is not a reasonable one but a subjective one testing whether the taxpayer actually had such intent regardless of whether it was reasonable or not.  (Certainly a diversion to my main point, but the even more startling thing here is that a necesssary conclusion from the Government's arguments is that it in fact proved beyond a reasonable doubt that they taxpayers themselves committed tax evasion, even though they were given no opportunity to defend themselves.)

Sure, Judge Kaplan mouthed the right words – the test is the intent of the taxpayers without qualifying whether it should be reasonable intent, but in the final analysis the jury had no specific evidence of the taxpayers’ intent and were left to conclude only that the taxpayers must not have had the intent because no reasonable taxpayer could have had such an intent. That is an objective test in the guise of a subjective one.

And, of course, the Government knows that it skirted the subjective nature of the subjective prong (that second subjective is not redundant here). I won’t pull out all the points in the brief where the Government fudges on this issue. But you can clearly see the bootstrap with reference to the Gibson Dunn memo. Gibson Dunn, a law firm, was engaged or more taxpayers to opine about the transaction. Gibson Dunn had some doubts and evidenced those doubts in a memo that the defendants were aware of contemporaneously. Notwithstanding Gibson Dunn’s concerns in the memo, some of the Gibson Dunn clients allegedly invested. The Government cites (br. 41-42) that memo as proof that the taxpayers’ “lack of a nontax motive was unquestionable.” I fail to see the logical connection there. I don’t think that the Government ever proved that each of the absent taxpayers in the counts of conviction ever read the memo. But even more breathtaking in its gall, is the Government’s claim that it is entitled to send people to jail on the assumption that the clients have to subjectively believe the same thing as a lawyer whose advice they did not follow. That is not the stuff, in my mind, of criminal tax cases.

The tragedy of all this, in my mind, is that, if these defendants were guilty of some conduct for which criminal penalties are appropriate, the Government had plenty of tools to do it. Tax perjury, aiding and assisting, tax obstruction and even the Klein defraud conspiracy (oops, that's right the jury acquitted on that charge). According to the Government's claims in the briefs, the transactions were laced with lies and pretenses which could have easily been the proper fulcrum into one or more of the other tax crimes with penalties that would have produce ample incarceration periods for the gravity of the claimed misconduct, but the Government chose to make multiple evasion claims that, in my judgment, are seriously questionable.

That is the thread of my argument. Maybe I’ll write more on it in another forum, but it tests the limits of what I imagine is appropriate for a blog.

Court Finds Tax Motivated Transactions are Bullshit (1/11/10)

In Wells Fargo & Company v. United States, 91 Fed. Cl. 35 (2010), the Court of Federal Claims shot down another SILO transaction. In the smoke and mirrors scheme, the Court denied depreciation and interest deductions. In lay terms, the court found that the transaction was just bullshit, meaning also, I guess, that the arguments to sustain the transaction were also bullshit. (Sort of like Vincent LaGuardia Gambini's (aka Vinny) pithy argument in My Cousin Vinny - "Uh... everything that guy just said is bullshit... Thank you.") For the audio, click here.

Now, the Court of Federal Claims could not dispense of the case on that articulated basis, but it did the legal equivalent in more legalese (and words). The legalease is that the transaction lacks economic substance (the recognized way to say that transactions are bullshit). So that is what the court did.

I don't think that these transactions are materially different than the transactions involved in the KPMG prosecutions; indeed at some level they may be worse. As I have said, criminal tax cases are all about the lie. And, there appears to have been lies in these transactions. As the Wells Fargo Court said in concluding its analysis of the depreciation deductions denying the depreciation (quoting the Fourth Circuit in BB&T Corp. v. United States, 523 F.3d 461, 477 (4th Cir. 2008).):

The IRS was entitled to view these SILO transactions for what they are, not what they purport to be. As the Fourth Circuit observed in BB&T, citing an Abraham Lincoln riddle from Rogers v. United States, 281 F.3d 1108, 1118 (10th Cir. 2002), "How many legs does a dog have if you call a tail a leg?"

The answer is 'four,' because 'calling a tail a leg does not make it one.' Id. Here, BB&T styled the LILO as a lease financed by a loan, but did not in substance acquire a genuine leasehold interest or incur genuine indebtedness. Accordingly, . . . whether it has 'reached the point where the tax tail began to wag the dog,' Hines, 912 F.2d at 741, we conclude that the Government was entitled to recognize that tail for what it was, not what BB&T professed it to be.

BB&T, 523 F.3d at 477. The Court agrees fully with the Fourth Circuit's analysis in BB&T, and concludes that, looking at the substance of the SILO transactions, Wells Fargo did not become the owner for tax purposes of the SILO equipment, and is not entitled to the depreciation amounts claimed.

The Court also registered its disgust for this attempted stealth raid on the Treasury:

The SILO transactions here are offensive to the Court on many levels. A cadre of company executives, in concert with teams of well known legal and accounting firms and other consultants, regularly constructed and participated in these tax schemes for Wells Fargo, apparently blind to professional standards of care. Representatives from the Federal Transit Administration ("FTA") encouraged transit agencies to participate in SILO transactions as a way to raise additional funds, without seriously considering the probable adverse tax treatment of the transactions. Even when the IRS issued a 1999 Revenue Ruling disallowing tax deductions from LILO transactions, the participants continued on with only slight adjustments to create the SILO transactions. The Court has little sympathy for those who have lost out as a result of this decision.

Update on 1/12/10 at 11:50am:  I have corrected this blog to make bullshit a single word rather than two.  (I should note that I had it right in the quote from Vinny; that guy knows how to spell.)  For more on bullshit, there are two good Wikipedia entries -- one is general on bullshit here and the other is on Harry Frankfurt's "On Bullshit" here.  For the published version of Franfurt's landmark thoughts, see here; for the earlier non-published version of Frankfurt's landmark essay on bullshit, see here.

Update on 8/20/11:  The trial court's decision was affirmed in Wells Fargo & Company v. United States, 641 F.3d 1319 (Fed. Cir. 2011).

Tax Shelters, Economic Substance and Tax Crimes

On November 10, the Fifth Circuit decided Enbridge Energy Company, Inc. v. United States, 2009 U.S. App. LEXIS 24713 (5th Cir. 2009). The guts of the holding was that (i) the district court properly denied the tax benefits from a common so-called midco transaction because of lack of economic substance and (ii) the district court properly imposed the accuracy related penalty because the transaction lacked substantial authority and, in any event, the transaction was a tax shelter for which even the presence of substantial authority could avoid the penalty.

The decision is per curiam and unpublished (meaning that it's precedential status is limited), nevertheless I think the opinion is interesting – and perhaps cautionary – because of its tenor and relationship to some of my other blogs on economic substance. I have questioned the use of the economic substance concept in criminal cases, but the government and courts in criminal cases do use it.

Focusing on Enbridge, the Fifth Circuit and the district court viewed the structure employed to avoid tax as lacking economic substance. The question I ask my readers is whether the Enbridge gambit should or at least could have been a criminal case? Wouldn't a few criminal cases with this genre of allegedly abusive tax shelters go a long way toward getting at least the major players (taxpayers and their enablers) out of the hokey tax shelter market?

Economic Substance in Tax Crimes

In American Boat LLC v. United States, ___ F.3d ___ (7th Cir. 2009), the Seventh Circuit affirmed a district court's holding that a taxpayer in a Son of Boss transaction was not liable for civil penalties for claiming the tax shelter on his return (I need not differentiate the civil penalties for present purposes). The essence of the relief granted was that the taxpayer had reasonable cause because of the tax lawyer's involvement and opinion (essentially like the other opinions for Son of Boss). The shelter was Jenkens & Gilchrist shelter of the type for which the lawyers promoting it have been indicted. (See discussion of indictment here.)

Echoing the mantra in the Nixon Watergate debacle, the Court said that "Again, the focus is on what Jump [the taxpayer] knew or should have known at the time he obtained the opinion letter." Focusing on the issuer of the opinion in a criminal context, it seems to me that the issue is the same -- to paraphrase, the focus is on what the lawyer knew or should have known at the time he issued the opinion letter. I don't think my paraphrasing is particularly insightful, but I do think it is helpful to state the truism from time to time, for I think it will help focus on the issue I raised in my earlier blog yesterday (see here). Keep in mind that the lawyer is guilty of a tax crime only if he knew the law (i.e., the crime was both knowable and he knew it) and he intended to violate the law.
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Uncertainty in the Law and Willfulness

In an article in today's New York Times here, Adam Liptak discusses Justice Scalia's dissent from denial of certiorari in Sorich v. United States, 129 S.Ct. 1308 (2009). Justice Scalia's lament is that the "honest services" crime does not provide an intelligible standard for criminal conduct. This theme is presented in the tax cases from James forward requiring a knowable law for tax crimes. Since the tax law requires willfulness, defined as the intentional violation of a known legal duty, then the legal standard must be knowable so that the defendant -- any defendant, even the hypothetical reasonable defendant -- charged with the crime must be able to ascertain the legal standard in order to intend to violate the standard.

Mr. Liptak notes with respect to "honest services" that "If you can make sense of that phrase, you have achieved something that has so far eluded the nation’s appeals courts." As a result, it is fair to say that citizens cannot ascertain the legal standard with any certainty and, correspondingly, judges and juries cannot predictably hold them to that uncertain standard. This phenomenon, Justice Scalia notes, violates fundamental constitutional principles, and gives the prosecutors too much unchecked power to pick and choose their defendants in a wide swath of conduct. Liptak notes:
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Economic Substance in Criminal Cases - Is It About the Lie?

THIS BLOG WAS UPDATED AS OF 5/25/2009; IN REVISED LANGUAGE, I ATTEMPT TO CLARIFY MY ASSERTION THAT, IN APPLYING THE ECONOMIC SUBSTANCE DOTRINE IN CRIMINAL TAX SHELTER CASES, THE "OR" TEST MUST APPLY AND REQUIRES THAT THE GOVERNMENT PROVE FOR CONVICTION THAT (1) EACH OF THE TAX SHELER INVESTORS -- THE TAXPAYERS -- LIED (WHICH IS DIFFERENT THAN MERELY PROVING THAT A HYPOTHETICAL REASONABLE TAXPAYER COULD NOT HAVE MADE THE REPRESENTATION TRUTHFULLY) AND THAT (2) THE SHELTER ENABLERS MUST HAVE KNOWN THAT THE TAX SHELTER INVESTORS -- THE TAXPAYERS -- ACTUALLY LIED.

Yesterday, I blogged here about the decision in Klamath. In that case, the Fifth Circuit faced the conflict among the courts in the appolication of the economic substance doctrine in civil cases and held that the taxpayer must have both (i) objective economic sustance and (ii) a nontax business or profit motive. (Actually, the Fifth Circuit stated these two-prong requirements as three-prong requirements, but I conflate the second and third here.) I noted in that blog that the Government also trots out the economic substance doctrine issue in criminal cases involving tax shelters. On a related note, I previously blogged here about the claim by a federal prosecutor prominent in such criminal prosecutions that criminal tax shelter cases are about the lie. In this blog, I address these related themes.

In the criminal case from the monster indictment of 19 KPMG-related individuals, 13 of the original 19 defendants were dismissed for prosecutorial misconduct. Only six of the original 19 thus were left. Two of those pled. The Government tried the remaining 4 defendants in late 2008. As to the BLIPS shelter (the same type of shelter involved in Klamath), the Government claimed in the case that the defendants criminally crossed the line established by the economic substance doctrine. Recognizing that there is a conflict among the courts as to the interpretation of the economic substance doctrine and that a criminal tax violation requires a clearly defined line that must be crossed, Judge Kaplan submitted the most defendant-friendly iteration of the economic substance doctrine to the jury. After charging the jury on Cheek willfulness, Judge Kaplan instructed as follows (United States v. Ruble, 2009 U.S. Dist. LEXIS 34908 (S.D.N.Y. 2009)):

[Y]ou may find that a defendant acted willfully in this respect only if the government has persuaded you beyond a reasonable doubt that the defendant, first of all, knew that the relevant taxpayer was motivated by no business purpose apart from the creation of a tax deduction. Secondly, knew that the strategy in question had no reasonable possibility of making a profit, in excess of the costs incurred without regard to tax benefits. And, thirdly, knew that the tax due and owing absent the deduction attributable to the strategy in question, would have been substantially greater than the tax reported on the taxpayer's tax return.

Note that, as presented to the jury, the jury could and should have acquitted if either of the key elements -- no nontax business purpose or no reasonable possibility of profit (a variation on objective economic substance) -- was not proven beyond a reasonable doubt. In other words, for purposes of the criminal case, the test is in the disjunctive rather than the conjunctive. The failure to prove either element would cause the criminal case to fail. And this is as it should be given the fact that there is some remaining uncertainty, even after Klamath, as to whether the test is conjunctive or disjunctive in civil cases. So, Judge Kaplan presented the most defendant-friendly application of the test, as he should do given the fact that a clear line is required both for Cheek willfulness and the rule of lenity. The jury then convicted the defendants for the BLIPS shelters.

Now, what has that got to do with the lie which, as noted in the previous post, is asserted to be the bedrock of criminal cases in the tax shelter area? In the BLIPS tax shelter, the Government claimed and the proof suggested, that the investment strategy independent of the "borrowing" transaction giving rise to the tax play had only a highly speculative possiblity of returning proceeds in excess of the all-in costs of the combined transaction (those costs consisting principally upon the promoters fees based ad valorem on the touted tax benefits alleged to be derived). (I note that the instructions did not surgically separate the investment play from the borrowing play which gave rise to the tax benefit, as the court did in Klamath but which the court did not do in Sala which is currently on appeal to the Tenth Circuit.) Hence, when the investors made the obligatory nontax profit motive representation to KPMG and to Ruble, given the marginality of the possibility of profit on the invesment play, they lied. Although it is impossible to know precisely why a jury convicts, at least the notion or speculation would be that the jury believed the taxpayers lied in making that key representation and that the defendant-enablers who received and relied upon that "representation" knew that the taxpayers were lieing. This would mean that the taxpayer-friendly application of the economic substance doctrine would deny the taxpayers the benefit they claimed on their returns and the defendants thus would be guilty because the taxpayers' taxes then would have been underpaid.

That may be a bit confusing, so let's approach it another way. Focusing on the taxpayers (i.e., the shelter investors), at least for criminal purposes, they could have underpaid their taxes (a requirement for anyone to be convicted of tax evasion) only if, under the most taxpayer-friendly application of the economic substance doctrine, their taxes were actually underpaid. Under a taxpayer friendly version of the economic substance doctrine, the taxpayer does not underpay the tax if either the transaction has objective economic substance or the taxpayer had a profit motive. (The Court in Klamath, discussed here, said that expressly in adopting the majority approach to require both economic substance and a taxpayer nontax business or profit motive ("This particular situation highlights the logic of following the majority approach to the economic substance doctrine, because the minority approach would allow tax benefits to flow from transactions totally lacking in economic substance as long as the taxpayers offered some conceivable profit motive,")) But, all the courts have not adopted the "both" test approved in Klamath, and thus whether the test is both or or is still uncertain as to its ultimate resolution in the federal courts. Certainty in the law is required for criminal prosecution (a la James, Garber, Dahlstrom, Pirro), so the taxes should be deemed due for criminal purposes only under the more lenient "or" test. Assuming arguendo that the transaction has no objective economic substance, the tax is due for criminal purposes only if the taxpayer had no nontax business or profit purpose. But, the taxpayers represented that they did have a nontax business or profit purpose. So, correct instructions would require that the jury find that the taxpayers actually lied as to profit motive (a subjective determination as to what was in their minds) and that the defendant-enablers must have known they were lieing.

But, wait a minute, you might say, did the Government really prove in the case that each of the taxpayers involved in the counts of conviction lied (And, you might ask, if those taxpayers were lieing, why were they not also indicted?) While I did not attend the trial, I did review the daily transcripts. I don't think the Government made any serious attempt to prove beyond a reasonable doubt that each of those taxpayers lied other than from an inference that no reasonable taxpayer could have made the representation. That inference turns a subjective test (the taxpayer's profit motive) into an objective test (a reasonable taxpayer's profit motive). The test, however, is not objective, it is subjective. Many of those taxpayers did not even testify, and there was no other real evidence as to their states of mind in making the representation. Maybe at least some of those taxpayers really believed that the investment strategy would produce a profit (and made no attempt to distinguish the loan play from the investment play (see Sala)). In that case, the taxpayers did not lie, regardless of whether some hypothetical reasonable taxpayer might not have reached that same belief under the circumstances. And, if the taxpayers themselves really did not lie, then under the lenient "or" test which must be used for criminal purposes, they did not owe the tax.

In other words, even if the tax shelter enablers knew that no reasonable taxpayer could make the representation, since taxes for criminal purposes would be due only if in fact the taxpayers lied -- i.e., they had no actual profit motive, even an unreasonable one -- the tax due and owing element could not be established without proving the lie for each of the taxpayers involved in the counts of conviction.

I have discussed in a previous blog (see here) the heavy burden of proof on the Government for tax evasion convictions as a result of the required element of proof of tax due and owing by the taxpayer. The issue discussed here is just a variation of that theme, although in an important but different context.

So, are the convictions flawed? We'll see on appeal.

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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