Showing posts with label emc. Show all posts
Showing posts with label emc. Show all posts
Wednesday, April 27, 2011
Should IRS Gets Extra Time to Nuke Abusive Shelters ?
HOME CONCRETE AND SUPPLY, LLC v. U.S. 107 AFTR 2d 2011-767
BEARD v. COMM. 107 AFTR 2d 2011-552
GRAPEVINE IMPORTS, LTD v. U.S., Cite as 107 AFTR 2d 2011-1288
Back in October I wrote about Fidelity International Currency, the epic story of EMC founder Richard Egan's doomed tax shelters. One of the things that I highlighted in the case was attorney Stephanie Denby's meticulous documentation of the thought process that went into the transactions:
Denby also rated and commented with respect to the manner in which the tax loss was generated, noting a plus if the transaction was “harder for [the] IRS to find” and a minus if the transaction was “easier” for the IRS to find.
Denby also rated and commented with respect to their complexity, noting a plus if the complexity of the structure made it harder for the IRS to “unwind” or “pick-up” and a minus if the simplicity of the structure made it easier for the IRS to trace.
One of her comments concerned basis:
Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more discrete [sic] and less likely I believe to cross the IRS radar screen.
It reminded me of an apocryphal story about an accountant who advised his clients "Put in puchases. They never look there.", whenever he encountered a disbursement of dubious deductibility.
One of the commnents on that post was:
Jeff said...
ignoring the effectiveness of the reg, this case certainly shows the need for reg §301.6501(e)-1T(a)(1)(iii).
What's that about besides proving that Jeff is even more of a tax geek than I am ? Here's the deal. The statute of limitations is three years on tax returns. That means that if you filed timely you can relax about 2007. Of course there are exceptions. There are always exceptions, except when there aren't any, which would be an exception. The relevant one here is that if you omitted more than 25% of your gross income, the statute of limitations is 6 years. What the regualtion did for all returns that were still open in September of 2009 was "clarify" that an overstatement of basis was an ommission from gross income.
Home Concrete was a fairly typical "get some basis with a one sided entry" type of deal:
On May 13, 1999, each of the taxpayers initiated short sales 1 of United States Treasury Bonds. In the aggregate, the taxpayers received $7,472,405 in short sale proceeds. Four days later, the taxpayers transferred the short sale proceeds and margin cash to Home Concrete as capital contributions. By transferring the short sale proceeds to Home Concrete as capital contributions, the taxpayers created “outside basis” equal to the amount of the proceeds contributed. 2 The next day, May 18, 1999, Home Concrete closed the short sales by purchasing and returning essentially identical Treasury Bonds on the open market at an aggregate purchase price of $7,359,043.
They weren't at all ashamed of what they did:
Home Concrete's 1999 tax return reported the basic components of the transactions. Its § 754 election form gave, for each partnership asset, an itemized accounting of the partnership's inside basis, the amount of the basis adjustment, and the post-election basis. The sum of the post-election bases is indicated at the end of the form. On its face, Home Concrete's return also showed a “Sale of U.S. Treasury Bonds” acquired on May 18, 1999 at a cost of $7,359,043, and a sale of those Bonds on May 19, 1999 for $7,472,405. The return also reported the resulting gain of $113,362. Similarly, the taxpayers' individual returns showed that “during the year the proceeds of a short sale not closed by the taxpayer in this tax year were received.”
Eventually the IRS caught on:
Notwithstanding these disclosures, the Internal Revenue Service (“IRS”) did not investigate the taxpayers' transactions until June 2003. The IRS issued a summons to Jenkins & Gilchrist, P.C., the law firm that assisted the taxpayers with the transactions, on June 19, 2003. The parties agree that substantial compliance with the IRS summons did not occur until at least May 17, 2004.
As a result of the investigation, on September 7, 2006 the IRS issued a Final Partnership Administrative Adjustment (“FPAA”), decreasing to zero the taxpayers' reported outside bases in Home Concrete and thereby substantially increasing the taxpayers' taxable income.
Absent the six year statute, they were too late. They tried to argue that since the case hadn't been decided by September of 2009, the new regulation should apply, but the Court wasn't buying it:
In Colony, Inc. v. Commissioner of Internal Revenue, the United States Supreme Court held that an overstatement of basis in assets resulting in an understatement of reported gross income does not constitute an “omission” from gross income for purposes of extending the general three-year statute of limitations for tax assessments. 357 U.S. 28 [1 AFTR 2d 1894] (1958). Because Colony squarely applies to this case, and because we will not defer to Treasury Regulation § 301.6501(e)-1(e), which was promulgated during this litigation and, by its own terms, does not apply to the tax year at issue, we reverse and hold that the tax assessments at issue here were untimely.
The Beard decision was a similar deal. The Court gave a nice summary of the concept:
Short selling is often a way to hedge against the market, but a Son-of-BOSS transaction relies on the delayed tax recognition of a short sale for a gamble of a different kind. In Son-of-BOSS, the taxpayer contributes the proceeds of the short and the corresponding obligation to close out the short to another legal entity in which he has ownership rights (usually a partnership). The taxpayer (or, perhaps more accurately, the tax-avoider) then sells his rights in the partnership, claiming an inflated outside basis in the partnership corresponding to the amount of the transferred proceeds without an offsetting basis reduction for the transferred liability. This is advantageous for the taxpayer because the capital gains tax on such a transaction is calculated by subtracting the outside basis from the amount recognized in the sale of the ownership rights, so a higher outside basis means lower capital gains tax and more money in the pocket of the taxpayer. Therefore, the gamble in the Son-of-BOSS transactions was that the participant could legally increase his outside basis in a partnership by not reporting the offsetting transferred contingent liability of the short position on his tax return.
The timing in Beard was similar. It was a 1999 return that the IRS did not catch up with until 2006. The Court in Beard (Seventh Circuit as opposed to Fourth Circuit in Home Concrete) concluded that in a non-business transaction the six year statute applies:
Using these definitions and applying standard rules of statutory construction to give equal weight to each term and avoid rendering parts of the language superfluous, we find that a plain reading of Section 6501(e)(1)(A) would include an inflation of basis as an omission of gross income in non-trade or business situations. See Regions Hospital v. Shalala, 522 U.S. 448, 467 (1997); Hawkins v. United States, 469 F.3d 993, 1000 (Fed. Cir. 2006). It seems to us that an improper inflation of basis is definitively a “leav[ing] out” from “any income from whatever source derived” of a quantitative “amount” properly includible. There is an amount—the difference between the inflated and actual basis—which has been left unmentioned on the face of the tax return as a candidate for inclusion in gross income.
They get there without even considering the IRS regulation. Had they needed it, though, they would have used it:
Much ink has been spilled in the briefs over whether temporary Treasury Regulation Section 301.6501(e)-1T(a)(1)(iii) would be entitled to Chevron deference if Colony were found to be controlling. This temporary regulation, which was issued without notice and comment at the same time as an identical proposed regulation, purports to offer taxpayers guidance by resolving an open question and stating definitively that in the case of a disposition of property, an overstatement of basis can lead to an omission from gross income. This temporary regulation has since been replaced by a nearly identical final regulation, issued after a notice and comment period. T.D. 9511 (eff. Dec. 14, 2010), 75 Fed. Reg. 78,897. Because we find that Colony is not controlling, we need not reach this issue. However, we would have been inclined to grant the temporary regulation Chevron deference, just as we would be inclined to grant such deference to T.D. 9511.
Grapevine Imports was close to an identical fact pattern to Home Concrete even to the extent of partiotically using contracts on US Treasuries to create phony basis. In Grapevine, the Federal Circuit reviewing a Court of Claims decisions says that the new regulations make all the difference:
The new Treasury regulations cannot, of course, change the Tax Code. But they may reflect the Treasury Department's exercise of authority granted by Congress to interpret an ambiguity in that code. Where an executive department, entrusted with interpretive authority, promulgates statutory interpretations that are reasonable within the circumstances established by Congress, then the courts must defer to that interpretation. Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 843–44 (1984).
When the Court of Federal Claims entered judgment for Grapevine, the Treasury Department had not yet exercised its interpretive authority over the limitations periods at issue in this case. It now has, and we, like the Court of Federal Claims, are obliged to defer to that interpretation. We therefore reverse the entry of judgment for Grapevine and remand for further proceedings.
Frankly this stuff is all a little too lawerly for me being a simple minded CPA, who loves debits to equal credits. I would like to extract a practical lesson from it. There are probably some people who did Son of Boss deals or similar offenses against the fundamentals of double entry in 2005 or maybe even 2004 who thought they were home free and now have to start sweating again, while they vigorously root for the Fouth Circuit. The lesson is this. If you are thinking about a transaction or return filing positions and find yourself getting into a discussion of whether a three year statute or a six year statute would apply, just don't do it.
P.S.
I did a follow-up on this as the Tax Court just issued another ruling on this issue.
Wednesday, January 19, 2011
The Saga Continues
FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC v. U.S., Cite as 106 AFTR 2d 2010-7404, 12/20/2010
The story of Richard Egan's doomed tax shelters continues. I thought I picked up the end of it in my post in October to which I provided a sequel with some followup commentary in my post on Krause v US. It turns out that I get to add a fourth volume to the EMC trilogy. Not being a litigator (or any other type of lawyer), I normally wouldn't pay any attention to something like this, but I've grown attached to this case. Also, it is noteworthy that the Egan family's legal team has finally won at least a partial victory. Maybe that's putting it a little too strongly.
This decision is about the cost of the cases. I guess the way it works is that the Egan team lost spectacularly enough that they have to pay some of the costs incurred by the federal government. It seems a little petty of the feds, but there is a big deficit and every little bit helps, I guess. The government was seeking $220,944.65, which seems like quite a handsome sum. You have to remember, though that, there was about $80,000,000 in tax and penalties at stake in the case.
Some of the discussion is illuminating
The electronically recorded transcripts must still be “necessarily obtained” for use in the case. Plaintiffs contend that video deposition expenses are not recoverable if the witness testifies at the trial, and objects to $18,791.00 in such costs claimed by defendant. That proposition is certainly doubtful as to witnesses (such as Stephanie Denby) who resided out-of-state and who may not have been available to testify at the trial. Furthermore, and in any event, in this case—particularly given its extreme complexities and uncertainties as to how and when the case would be tried and who would be then available to testify—the videotaping of the nine identified witnesses who later testified at trial was appropriate and necessary and properly taxable as a cost.
Stephanie Denby's e-mails were some of the best material in the original decision. I'd love to see her testimony, but I don't think they are planning on recovering some of the money in this case from releasing it on Netflix.
Plaintiffs object to the inclusion of $19,200 in printing and mounting costs for demonstrative exhibits, on the grounds that such exhibits were primarily presented electronically and were not necessary for use at trial. The government certainly was correct to make extensive use of demonstrative exhibits, given the complexity of the trial. The use of paper demonstrative exhibits was very helpful to the Court. The Court has reviewed the invoices submitted by the government, and is not prepared to reject them as unnecessary or excessive based on the evidence provided.
I wonder if there were circle and arrows and a paragraph on the back of each one explaining what it was.
Plaintiffs next object to the cost of printing the entire production of the Stephanie Denby documents during the trial. Under the circumstances, where the documents were not produced until relatively late, the cost was a necessary incident to the trial and will be allowed.
I guess the e-mails that were quoted in the decision were just the highlights.
There were a few other issues. In the end the court disallowed:
$17,328.12, reflecting the cost of expedited transcripts;
$26,626.90, reflecting the cost of "real time" deposition transmissions;
$12,183.54, reflecting the cost of "real time" trial transmissions;
$1,200.00, reflecting the cost of the rented copier;
$2,666.07, reflecting the cost of "miscellaneous supplies";
$83.19, reflecting the cost of "general and admin[istrative] expense; and
$5,808.28, reflecting a reduction of 3/7 of the trial exhibit copying costs.
----------
$65,896.10
All in, I make that to be a victory of 0.08% for the Egans.
The story of Richard Egan's doomed tax shelters continues. I thought I picked up the end of it in my post in October to which I provided a sequel with some followup commentary in my post on Krause v US. It turns out that I get to add a fourth volume to the EMC trilogy. Not being a litigator (or any other type of lawyer), I normally wouldn't pay any attention to something like this, but I've grown attached to this case. Also, it is noteworthy that the Egan family's legal team has finally won at least a partial victory. Maybe that's putting it a little too strongly.
This decision is about the cost of the cases. I guess the way it works is that the Egan team lost spectacularly enough that they have to pay some of the costs incurred by the federal government. It seems a little petty of the feds, but there is a big deficit and every little bit helps, I guess. The government was seeking $220,944.65, which seems like quite a handsome sum. You have to remember, though that, there was about $80,000,000 in tax and penalties at stake in the case.
Some of the discussion is illuminating
The electronically recorded transcripts must still be “necessarily obtained” for use in the case. Plaintiffs contend that video deposition expenses are not recoverable if the witness testifies at the trial, and objects to $18,791.00 in such costs claimed by defendant. That proposition is certainly doubtful as to witnesses (such as Stephanie Denby) who resided out-of-state and who may not have been available to testify at the trial. Furthermore, and in any event, in this case—particularly given its extreme complexities and uncertainties as to how and when the case would be tried and who would be then available to testify—the videotaping of the nine identified witnesses who later testified at trial was appropriate and necessary and properly taxable as a cost.
Stephanie Denby's e-mails were some of the best material in the original decision. I'd love to see her testimony, but I don't think they are planning on recovering some of the money in this case from releasing it on Netflix.
Plaintiffs object to the inclusion of $19,200 in printing and mounting costs for demonstrative exhibits, on the grounds that such exhibits were primarily presented electronically and were not necessary for use at trial. The government certainly was correct to make extensive use of demonstrative exhibits, given the complexity of the trial. The use of paper demonstrative exhibits was very helpful to the Court. The Court has reviewed the invoices submitted by the government, and is not prepared to reject them as unnecessary or excessive based on the evidence provided.
I wonder if there were circle and arrows and a paragraph on the back of each one explaining what it was.
Plaintiffs next object to the cost of printing the entire production of the Stephanie Denby documents during the trial. Under the circumstances, where the documents were not produced until relatively late, the cost was a necessary incident to the trial and will be allowed.
I guess the e-mails that were quoted in the decision were just the highlights.
There were a few other issues. In the end the court disallowed:
$17,328.12, reflecting the cost of expedited transcripts;
$26,626.90, reflecting the cost of "real time" deposition transmissions;
$12,183.54, reflecting the cost of "real time" trial transmissions;
$1,200.00, reflecting the cost of the rented copier;
$2,666.07, reflecting the cost of "miscellaneous supplies";
$83.19, reflecting the cost of "general and admin[istrative] expense; and
$5,808.28, reflecting a reduction of 3/7 of the trial exhibit copying costs.
----------
$65,896.10
All in, I make that to be a victory of 0.08% for the Egans.
Wednesday, November 3, 2010
Courts and Value Billing
.
Canal Corporation and Subsidiaries v. Commissioner, 135 T.C. No. 9
KELLER, ET AL. v. U.S., Cite as 106 AFTR 2d 2010-6343, 09/15/2010
My father was fond of saying you need three things in life – a good doctor, a forgiving priest, and a clever accountant
I have these little stories I use to keep perspective. They are a combination of fact and speculation. The proportions vary. I sometimes hear that being a CPA is very stressful. I can get into that, but then I have my perspective story. Sometime, during the early part of the second Gulf War, my daughter's eighth grade class wrote encouraging letters to our service people abroad. I wasn't surprised that she got a reply, but the person replying was a bit of a surprise. He was a major, the executive officer of a helicopter battalion. I tried to imagine what his job must be like. It involves seeing that machines that don't look like they should fly keep flying. And that's just the tip of the iceberg. My speculation was that he received a stack of letters and that faced with the challenge of making sure that his collection of extremely stressed young people appropriately answered the schoolchildren in a way that reflected credit on the Army, he answered them all himself. Regardless it was a nice letter and I hope that he is now full colonel at a nice post in pleasant circumstance or perhaps even better collecting a well earned lieutenant colonel's pension. And when ever I think I have stress I think about him.
I believe that the biggest hazard CPA's face is not stress, but envy. It is in the nature of things that most CPA's who do well have client's who do even better, much better. In a free capitalist society, the most highly compensated people will be the successful entrepreneurs. That does not mean that entrepreneurial activity is over rewarded. Unsuccessful entrepreneurship garners fairly heavy penalties. In the process of failure, they may generate some complicated accounting work, but not the revenue to pay for it. A practice where those clients predominate, unless it is that of some sort of workout specialist, will not last. So a prosperous CPA sitting down to eat with a collection of his most prosperous clients will often be the least prosperous person at the table. Ironically, the more prosperous the CPA is, the more likely that he or she will be the least prosperous person at that particular table.
The concept of value billing has some very sound reasoning behind it, but I also think that the envy factor is the source of some of its attraction. I couldn't help but notice it in the banter between professionals that was such a rich part of Fidelity International Currency, the epic tale of EMC founder Richard Egan's doomed tax shelters
On May 26, 2000, Denby sent Reiss an e-mail regarding the previous day's meeting and her discussions with Helios after the meeting concerning fees:
... after the meeting I discussed with Helios the fees. The fees are based on a 3% rate. If KPMG were not involved Helios would just pocket a larger percentage. Since our connection came from KPMG, Helios would pay them a referral fee anyway. I think at the same rate. So [their] involvement does not cost more but just results in reallocation of the base fee. I know from other situations this reallocation occurs simply from [our] getting the name [from] KPMG. We are in the wrong business!
The writer was an attorney and the recipient a CPA, who was CFO of a family office. She was expressing the same frustration that led the CPA's at KPMG into a new and interesting way to do business. She or her firm was apparently getting paid by the hour to find a brilliant maneuver to save Mr. Egan's tax dollars. KPMG had already invested some hours in designing a brilliant scheme. They would not get paid for the additional hours they spent applying these principles to Mr. Egan's situation. They would get paid a percentage of the tax savings while incurring a relatively small marginal cost.
The outcome of the whole enterprise was not pretty for KPMG or many of their clients. KPMG found itself fortunate to be in any business. They were even pressured by the federal government to stop paying defense costs for some of their partners, a tactic which back fired on the government on constitutional grounds, but you should go to the federal tax crimes blog if you want to read about that type of thing. More to the point of this post, none of the opinions that the Egans paid for protected them from the imposition of penalties. They were viewed as part of the package and tainted by a lack of independence.
The disdain for professional imprimaturs unsupported by work has moved beyond the Son of Boss unbalanced entries to a deal that tax professionals felt deserved a bit more respect. Canal Corporation and Subsidiaries was a deferral deal. Instead of selling a subsidiary the taxpayer contributed it to a partnership and took a large distribution. The debt that funded the distribution was allocated to the contributing partner, which avoids the disguised sale rules. Of course, they didn't really want a liability, so the guarantee that supported the allocation was pretty tenuous.
Not to worry, they got a "should" opinion, the highest assurance possible from none other than PWC. If you can't rely on the people who count the votes for the academy awards, who can you rely on ? Turns out the client should have been a little more diligent than just cutting a check and asking for the envelope, please :
Chesapeake paid PWC an $800,000 flat fee for the opinion, not based on time devoted to preparing the opinion. Mr. Miller testified that he and his team spent hours on the opinion. We find this testimony inconsistent with the opinion that was admitted into evidence. The Court questions how much time could have been devoted to the draft opinion because it is littered with typographical errors, disorganized and incomplete. Moreover, Mr. Miller failed to recognize several parts of the opinion. The Court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion.
We are also nonplused by Mr. Miller's failure to give an understandable response when asked at trial how PWC could issue a “should” opinion if no authority on point existed. He demurred that it was what Chesapeake requested. The only explanation that makes sense to the Court is that no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion
Chesapeake did not act with reasonable cause or in good faith as it relied on Mr. Miller's advice. Chesapeake argues that it had every reason to trust PWC's judgment because of its long-term relationship with the firm. PWC crossed over the line from trusted adviser for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag—$800,000.
The Keller opinion sheds a different light on the subject. It is a follow up to the Keller case which I mentioned briefly at the dawn of this blog noting that the role of the accountant bordered on the heroic. There was a family limited partnership all set to go with assets identified, etc., etc. Then the matriarch dies before she can sign anything. Don't you hate when that happens ? So her estate tax of 147,000,000 or so was computed with no valuation discount. Then one of the family's accountants got the notion that maybe they had gone far enough. So they sued for refund and in August of 2009, they won. The case came up again to determine deductible fees. Although the court was very deferential to the executor/accountant, they decided that a $2,400,000 "bonus" for future worker was not ordinary and necessary. They also disallowed a $9,470,606 contingency fee to attorneys (presumably the ones who handled the litigation on the valuation discounts).
Pricing on Purpose is a really good book and it offers some valuable perspectives on approaches for billing for professional services. I think, though, that these decisions raise some issues on the value of tax services that are detached from the amount of work that is involved. It is almost as if when you try to bill based on the value, the value disappears.
My final reflection is advice for the financial professionals who have those twinges of envy when they see the big checks is to try three techniques. The first is to go to the kitchen and get a glass of water from the tap and drink it. While you do that reflect on how few people in world historical terms have had such easy access to reasonably potable water. The second is that the next time somebody in the street asks your for money, engage with them. Ask them when they have last eaten and then sit down and have lunch with them. (If they are professional pan handlers, they will find this rather frustrating). If all else fails do a google search on "KPMG Tax Shelter Prison". It may well be that Attorney Denby was in the wrong business, but that didn't mean KPMG was in the right business.
I'm not giving up on the quote identifying contest. The one at the top is from a film and at the risk of making it too easy I will say the real hero of the film was an accountant (although he is not the "hero" of the film). Also Xavier graduates and old people probably don't have an edge on this one.
Canal Corporation and Subsidiaries v. Commissioner, 135 T.C. No. 9
KELLER, ET AL. v. U.S., Cite as 106 AFTR 2d 2010-6343, 09/15/2010
My father was fond of saying you need three things in life – a good doctor, a forgiving priest, and a clever accountant
I have these little stories I use to keep perspective. They are a combination of fact and speculation. The proportions vary. I sometimes hear that being a CPA is very stressful. I can get into that, but then I have my perspective story. Sometime, during the early part of the second Gulf War, my daughter's eighth grade class wrote encouraging letters to our service people abroad. I wasn't surprised that she got a reply, but the person replying was a bit of a surprise. He was a major, the executive officer of a helicopter battalion. I tried to imagine what his job must be like. It involves seeing that machines that don't look like they should fly keep flying. And that's just the tip of the iceberg. My speculation was that he received a stack of letters and that faced with the challenge of making sure that his collection of extremely stressed young people appropriately answered the schoolchildren in a way that reflected credit on the Army, he answered them all himself. Regardless it was a nice letter and I hope that he is now full colonel at a nice post in pleasant circumstance or perhaps even better collecting a well earned lieutenant colonel's pension. And when ever I think I have stress I think about him.
I believe that the biggest hazard CPA's face is not stress, but envy. It is in the nature of things that most CPA's who do well have client's who do even better, much better. In a free capitalist society, the most highly compensated people will be the successful entrepreneurs. That does not mean that entrepreneurial activity is over rewarded. Unsuccessful entrepreneurship garners fairly heavy penalties. In the process of failure, they may generate some complicated accounting work, but not the revenue to pay for it. A practice where those clients predominate, unless it is that of some sort of workout specialist, will not last. So a prosperous CPA sitting down to eat with a collection of his most prosperous clients will often be the least prosperous person at the table. Ironically, the more prosperous the CPA is, the more likely that he or she will be the least prosperous person at that particular table.
The concept of value billing has some very sound reasoning behind it, but I also think that the envy factor is the source of some of its attraction. I couldn't help but notice it in the banter between professionals that was such a rich part of Fidelity International Currency, the epic tale of EMC founder Richard Egan's doomed tax shelters
On May 26, 2000, Denby sent Reiss an e-mail regarding the previous day's meeting and her discussions with Helios after the meeting concerning fees:
... after the meeting I discussed with Helios the fees. The fees are based on a 3% rate. If KPMG were not involved Helios would just pocket a larger percentage. Since our connection came from KPMG, Helios would pay them a referral fee anyway. I think at the same rate. So [their] involvement does not cost more but just results in reallocation of the base fee. I know from other situations this reallocation occurs simply from [our] getting the name [from] KPMG. We are in the wrong business!
The writer was an attorney and the recipient a CPA, who was CFO of a family office. She was expressing the same frustration that led the CPA's at KPMG into a new and interesting way to do business. She or her firm was apparently getting paid by the hour to find a brilliant maneuver to save Mr. Egan's tax dollars. KPMG had already invested some hours in designing a brilliant scheme. They would not get paid for the additional hours they spent applying these principles to Mr. Egan's situation. They would get paid a percentage of the tax savings while incurring a relatively small marginal cost.
The outcome of the whole enterprise was not pretty for KPMG or many of their clients. KPMG found itself fortunate to be in any business. They were even pressured by the federal government to stop paying defense costs for some of their partners, a tactic which back fired on the government on constitutional grounds, but you should go to the federal tax crimes blog if you want to read about that type of thing. More to the point of this post, none of the opinions that the Egans paid for protected them from the imposition of penalties. They were viewed as part of the package and tainted by a lack of independence.
The disdain for professional imprimaturs unsupported by work has moved beyond the Son of Boss unbalanced entries to a deal that tax professionals felt deserved a bit more respect. Canal Corporation and Subsidiaries was a deferral deal. Instead of selling a subsidiary the taxpayer contributed it to a partnership and took a large distribution. The debt that funded the distribution was allocated to the contributing partner, which avoids the disguised sale rules. Of course, they didn't really want a liability, so the guarantee that supported the allocation was pretty tenuous.
Not to worry, they got a "should" opinion, the highest assurance possible from none other than PWC. If you can't rely on the people who count the votes for the academy awards, who can you rely on ? Turns out the client should have been a little more diligent than just cutting a check and asking for the envelope, please :
Chesapeake paid PWC an $800,000 flat fee for the opinion, not based on time devoted to preparing the opinion. Mr. Miller testified that he and his team spent hours on the opinion. We find this testimony inconsistent with the opinion that was admitted into evidence. The Court questions how much time could have been devoted to the draft opinion because it is littered with typographical errors, disorganized and incomplete. Moreover, Mr. Miller failed to recognize several parts of the opinion. The Court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion.
We are also nonplused by Mr. Miller's failure to give an understandable response when asked at trial how PWC could issue a “should” opinion if no authority on point existed. He demurred that it was what Chesapeake requested. The only explanation that makes sense to the Court is that no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion
Chesapeake did not act with reasonable cause or in good faith as it relied on Mr. Miller's advice. Chesapeake argues that it had every reason to trust PWC's judgment because of its long-term relationship with the firm. PWC crossed over the line from trusted adviser for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag—$800,000.
The Keller opinion sheds a different light on the subject. It is a follow up to the Keller case which I mentioned briefly at the dawn of this blog noting that the role of the accountant bordered on the heroic. There was a family limited partnership all set to go with assets identified, etc., etc. Then the matriarch dies before she can sign anything. Don't you hate when that happens ? So her estate tax of 147,000,000 or so was computed with no valuation discount. Then one of the family's accountants got the notion that maybe they had gone far enough. So they sued for refund and in August of 2009, they won. The case came up again to determine deductible fees. Although the court was very deferential to the executor/accountant, they decided that a $2,400,000 "bonus" for future worker was not ordinary and necessary. They also disallowed a $9,470,606 contingency fee to attorneys (presumably the ones who handled the litigation on the valuation discounts).
Pricing on Purpose is a really good book and it offers some valuable perspectives on approaches for billing for professional services. I think, though, that these decisions raise some issues on the value of tax services that are detached from the amount of work that is involved. It is almost as if when you try to bill based on the value, the value disappears.
My final reflection is advice for the financial professionals who have those twinges of envy when they see the big checks is to try three techniques. The first is to go to the kitchen and get a glass of water from the tap and drink it. While you do that reflect on how few people in world historical terms have had such easy access to reasonably potable water. The second is that the next time somebody in the street asks your for money, engage with them. Ask them when they have last eaten and then sit down and have lunch with them. (If they are professional pan handlers, they will find this rather frustrating). If all else fails do a google search on "KPMG Tax Shelter Prison". It may well be that Attorney Denby was in the wrong business, but that didn't mean KPMG was in the right business.
I'm not giving up on the quote identifying contest. The one at the top is from a film and at the risk of making it too easy I will say the real hero of the film was an accountant (although he is not the "hero" of the film). Also Xavier graduates and old people probably don't have an edge on this one.
Friday, October 22, 2010
Wag the Dog
You just couldn't play it smart, could you?
All you had to do was box, but no,
not you, you hardhead.
Funny thing is, there ain't gonna be
any boxing championships this year.
As I mentioned in my initial post on Fidelity International Currency Advisor, there is much material in the saga of Richard Egan's doomed tax shelters. I will wrap up my EMC trilogy with an observation on the greatest irony of the case. The Egan's had two partnerships one designed to shelter capital gain and the other ordinary income. I explained the capital gain scheme, but not the ordinary income one. Basically you get a free basis step-up by entering into offsetting option contracts and have an accountant handle one leg of the transaction and a tax attorney the other half. The debit goes on the left and the credit goes ... What credit ? The ordinary income refinement requires a foreign partner to be allocated gains and then be bought out. (Of course the buy-out cannot be prearranged wink, wink). This deal was done in 2000, a long time ago to some, but well after the 704(b) regulations were issued. Sadly the case does not explain the theory that deemed there to be substantial economic effect to the allocating of 160 million of gains to someone who was shortly bought out for around $325,000. That's not where I see the irony, though.
After a whirlwind tour of the Big Apple's accounting emproia where these brilliant maneuvers were presented Richard Egan, according to one of his advisers, told his son Michael, who headed his family office, that he wished his advisers would help make him money rather than save it. The advisor was told that she may have misheard and that "Dick" knows how to make money, but may not know how to save it. This presumably was how the advisers would distinguish themselves. One of the earliest events recorded in the case is something that James Reiss, CFO of Carruth Management (Egan's family office) wrote to attorney Stephanie Denby:
On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father's EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” The “transaction” he had in mind was one that would avoid taxes.
By the fall of 2000, the price of EMC exceeded $100 per share and had it kept appreciating at a similar rate $140 would have been achieved before long. The effort involved in selecting just the right tax shelter and making sure it was properly documented took time. Once all that energy was expended there was a desire to make sure the paid-for basis was properly used. Sadly the market did not cooperate with the plan.
At the beginning of September 2000, EMC stock was trading at $98.00 per share. Thereafter, the share price of EMC steadily declined, with the exception of a small increase in January 2001. By the end of November 2001, EMC stock was trading at $16.79 per share.
The Fidelity High Tech transaction had created a purported “basis” of $ 160 million. As the price of EMC stock began to decline, however, it became apparent to Michael Egan and others that the stock could not be sold for a sufficient gain to take advantage of that entire “basis.” In addition, the Egans did not want to show a loss on the sale of the stock. Accordingly, in 2001 the Egans added additional low-basis stock to the High Tech Fund—a practice that was referred to as “stuffing.” As Haber advised Pat Shea, the Egans could “stuff [High Tech] with more stock to get our per share basis lower [--] that will allow us to sell shares tax free.”
At least as early as May 2001, Michael Egan was being provided with spreadsheets prepared by Carolyn Fiddy that set forth the fair market value of the stock held in High Tech. The spreadsheets showed how much additional stock would need to be contributed to bring the value of the portfolio up to the amount of the $160 million purported basis,
In late 2001, employees at Carruth performed further calculations in order to determine how much additional stock needed to be contributed to Fidelity High Tech in order to take advantage of the purported $160 million basis. In addition to EMC stock, Michael Egan authorized contribution of other low-basis stock owned by the Egans to Fidelity High Tech to take advantage of the “stepped-up” basis (or, as Shea put it, to “absorb” that basis).
On December 19, 2001, Carolyn Fiddy reported to Reiss that “the final “stuffing” for Fidelity High Tech Advisor A has been organized.” . The same day, Shea reported to Reiss that “the “stuffing” of Helios I [High Tech] took place today.” On December 20, Fiddy reported to Haber that “additional contributions of low basis stock” had been made to High Tech.
On December 20, 2001, Pat Shea reported to Haber that “we have “stuffed” this fund with several other assets including more EMC stock.”
The beauty of the transaction was that it would have a "low reporting profile" since it was "merely" eliminating gains rather than creating a loss. Ultimately the transaction would be showing a loss as there was not enough fair market value of EMC stock contributed to take advantage of the basis.
In the end the capital gains tax had to be paid and apparently a 40% gross valuation overstatement penalty. Not to metnion all the fees which were estimated to be around 20% of the "tax savings". The really interesting question, though, is how much was lost due to stock being sold at less favorable prices than might have been obtained without the complications of the shelter planning ?
The Egans were not the only people afflicted by the belief that EMC stock could only go up. And of course EMC was part of the larger tech bubble. Just for perspective we can reflect on what might have happened to many of the EMC rankers. The belief that tax laws are rigged in favor of the ultra wealthy is really a delusion. Mr. Egan had to get somebody to find a friendly Irishman to pick up 160,000,000 dollars in currency gain and then be bought out to shelter his non-qualified option ordinary income. A regular EMC employee would have qualified options. So if such an employee exercised an option to buy at say $20 when the stock was at $90 all he or she had to do was hold onto the stock for a year in order to get capital gains treatment on the $70 plus of course the additional amount that the EMC stock would go up by in the course of the year. Of course there was that nasty alternative minimum tax so maybe there would be $15 or so to pay in April, which might have been about what the stock finally sold for. So as they stretched to turn a 40% tax into a 20 % tax, they ended up with, in effect, a 100% tax. They ended up with AMT credit carryovers and AMT capital loss carryovers, many of which have been used by now, but it was really painful in 2001.
The usual prize of the privilege of naming a topic for a future goes for identifying the quotation leading the post. In order to get full credit you have to name the historic event that corresponds to the tech bubble in the analogy that I am creating.
All you had to do was box, but no,
not you, you hardhead.
Funny thing is, there ain't gonna be
any boxing championships this year.
As I mentioned in my initial post on Fidelity International Currency Advisor, there is much material in the saga of Richard Egan's doomed tax shelters. I will wrap up my EMC trilogy with an observation on the greatest irony of the case. The Egan's had two partnerships one designed to shelter capital gain and the other ordinary income. I explained the capital gain scheme, but not the ordinary income one. Basically you get a free basis step-up by entering into offsetting option contracts and have an accountant handle one leg of the transaction and a tax attorney the other half. The debit goes on the left and the credit goes ... What credit ? The ordinary income refinement requires a foreign partner to be allocated gains and then be bought out. (Of course the buy-out cannot be prearranged wink, wink). This deal was done in 2000, a long time ago to some, but well after the 704(b) regulations were issued. Sadly the case does not explain the theory that deemed there to be substantial economic effect to the allocating of 160 million of gains to someone who was shortly bought out for around $325,000. That's not where I see the irony, though.
After a whirlwind tour of the Big Apple's accounting emproia where these brilliant maneuvers were presented Richard Egan, according to one of his advisers, told his son Michael, who headed his family office, that he wished his advisers would help make him money rather than save it. The advisor was told that she may have misheard and that "Dick" knows how to make money, but may not know how to save it. This presumably was how the advisers would distinguish themselves. One of the earliest events recorded in the case is something that James Reiss, CFO of Carruth Management (Egan's family office) wrote to attorney Stephanie Denby:
On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father's EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” The “transaction” he had in mind was one that would avoid taxes.
By the fall of 2000, the price of EMC exceeded $100 per share and had it kept appreciating at a similar rate $140 would have been achieved before long. The effort involved in selecting just the right tax shelter and making sure it was properly documented took time. Once all that energy was expended there was a desire to make sure the paid-for basis was properly used. Sadly the market did not cooperate with the plan.
At the beginning of September 2000, EMC stock was trading at $98.00 per share. Thereafter, the share price of EMC steadily declined, with the exception of a small increase in January 2001. By the end of November 2001, EMC stock was trading at $16.79 per share.
The Fidelity High Tech transaction had created a purported “basis” of $ 160 million. As the price of EMC stock began to decline, however, it became apparent to Michael Egan and others that the stock could not be sold for a sufficient gain to take advantage of that entire “basis.” In addition, the Egans did not want to show a loss on the sale of the stock. Accordingly, in 2001 the Egans added additional low-basis stock to the High Tech Fund—a practice that was referred to as “stuffing.” As Haber advised Pat Shea, the Egans could “stuff [High Tech] with more stock to get our per share basis lower [--] that will allow us to sell shares tax free.”
At least as early as May 2001, Michael Egan was being provided with spreadsheets prepared by Carolyn Fiddy that set forth the fair market value of the stock held in High Tech. The spreadsheets showed how much additional stock would need to be contributed to bring the value of the portfolio up to the amount of the $160 million purported basis,
In late 2001, employees at Carruth performed further calculations in order to determine how much additional stock needed to be contributed to Fidelity High Tech in order to take advantage of the purported $160 million basis. In addition to EMC stock, Michael Egan authorized contribution of other low-basis stock owned by the Egans to Fidelity High Tech to take advantage of the “stepped-up” basis (or, as Shea put it, to “absorb” that basis).
On December 19, 2001, Carolyn Fiddy reported to Reiss that “the final “stuffing” for Fidelity High Tech Advisor A has been organized.” . The same day, Shea reported to Reiss that “the “stuffing” of Helios I [High Tech] took place today.” On December 20, Fiddy reported to Haber that “additional contributions of low basis stock” had been made to High Tech.
On December 20, 2001, Pat Shea reported to Haber that “we have “stuffed” this fund with several other assets including more EMC stock.”
The beauty of the transaction was that it would have a "low reporting profile" since it was "merely" eliminating gains rather than creating a loss. Ultimately the transaction would be showing a loss as there was not enough fair market value of EMC stock contributed to take advantage of the basis.
In the end the capital gains tax had to be paid and apparently a 40% gross valuation overstatement penalty. Not to metnion all the fees which were estimated to be around 20% of the "tax savings". The really interesting question, though, is how much was lost due to stock being sold at less favorable prices than might have been obtained without the complications of the shelter planning ?
The Egans were not the only people afflicted by the belief that EMC stock could only go up. And of course EMC was part of the larger tech bubble. Just for perspective we can reflect on what might have happened to many of the EMC rankers. The belief that tax laws are rigged in favor of the ultra wealthy is really a delusion. Mr. Egan had to get somebody to find a friendly Irishman to pick up 160,000,000 dollars in currency gain and then be bought out to shelter his non-qualified option ordinary income. A regular EMC employee would have qualified options. So if such an employee exercised an option to buy at say $20 when the stock was at $90 all he or she had to do was hold onto the stock for a year in order to get capital gains treatment on the $70 plus of course the additional amount that the EMC stock would go up by in the course of the year. Of course there was that nasty alternative minimum tax so maybe there would be $15 or so to pay in April, which might have been about what the stock finally sold for. So as they stretched to turn a 40% tax into a 20 % tax, they ended up with, in effect, a 100% tax. They ended up with AMT credit carryovers and AMT capital loss carryovers, many of which have been used by now, but it was really painful in 2001.
The usual prize of the privilege of naming a topic for a future goes for identifying the quotation leading the post. In order to get full credit you have to name the historic event that corresponds to the tech bubble in the analogy that I am creating.
Monday, October 18, 2010
Debit by the Window - Credit out the Window
KRAUSE v. U.S., Cite as 106 AFTR 2d 2010-5382, 10/12/2010
There is an old joke about a CPA who used to come to work everyday, open his desk drawer and look at a slip of paper. After he retired someone found the slip of paper and saw written on it "Debits by the Window - Credits by the Door". If he went to law school and started doing Son of BOSS deals, he would have had to change it to something more in line with the title of this post.
My readers, who may well number in the scores, vary in their degree of tax geekiness. Those of you who come here out of friendship or because I have grovelled may want to just click on a few ads and move on, because this is one of those points that is a stretch for me. I feel I must comment on this synchronicity. My last two posts have been about Fidelity International Currency. The rather long decision was issued in May. It disallowed two partnerships which had been used by EMC founder Richard Egan to shelter capital gains from the sale of stock and ordinary income from the exercise of non-qualified options.
The decision was amended on October 6 to indicate that penalties would apply. Talk about waiting for the other shoe to drop. The Egans had already put up the 60 million or so in tax. Somehow I doubt they had been counting on the refund they were suing for to do their Christmas shopping. So the October 6 amendment might be what they were really sweating out. If the judge had wanted to make life even more difficult he would have waited until January. Mr. Egan died in August 2009 making the extended due date of his estate tax return fairly imminent. Presumably the penalty will go in as a debt of the estate.
In my post I indicated that since this was a partnership case, I was leaving it to the tax litigators as to whether that really was the venue for deciding individual penalties. Next time I take a break from October 15 returns and start crawling through decisions I find the case of J. Winston Krause. Mr. Krause was a tax attorney and CPA who built his own Son of BOSS shelter. I have to wonder if he has two sides to his personality. Right now the CPA side is yelling "Language of 752, language of 752 - I knew it couldn't work. The entry didn't balance. You can't get all that basis without crediting something." The tax attorney side has answers. I can show you an example of a CPA making beautifully balanced entries that make no impression on judges, who are lawyers.
Mr. Krause's partnership did not fight the disallowance of the Son of BOSS losses. He paid the assessed tax, penalty and interest and then sued for refund of the penalties. Mr. Krause, not being a high tech billionaire. "only" has about $112,000 in penalties. (I have a rule that the word "only" should not be used in connection with sums of money greater than four dollars, but I'm relaxing it in light of the Egan's 20 million plus penalty). In arriving at its ruling he court goes into a discussion on the partnership provisions of TEFRA. (Tax Equity and Fiscal Responsibility Act of 1982). The partnership provisions of TEFRA are a more subtle part of the war against tax shelters than passive activity loss rules of the Tax Reform Act of 1986. Without them each parter in a partnership could litigate the same transactions in tax court.
To avoid duplicative litigation stemming from the tax treatment of partnerships, Congress enacted TEFRA, which creates a unified procedure for determining the treatment of partnership tax transactions. TEFRA requires the differentiation between the tax treatment of partnership-level and partner-level items.Id . § 6221. Partnership items include all items of “income, gain, loss, deduction, or credit of the partnership,” along with “optional adjustments to the basis of partnership property pursuant to an election under section 754,” and “the accounting practices and the legal and factual determinations that underlie the determination of... items of income, credit, gain, loss, deduction, etc.”
The penalties assessed under the FPAA were directly attributable to the fraudulent $2.79 million loss KAAS alleged it incurred when it sold its Canadian currency. This loss, which passed through to Krause Holdings and then to Krause, occurred because of the overstated basis KAAS had claimed in the Canadian currency due to an earlier basis election. Thus, the penalty related to basis, basis adjustments, and losses, all of which are considered partnership items under § 6231
Further, the refund sought by Krause relates to penalties and penalty-related interest that are associated with partnership-level items, both of which are in and of themselves considered partnership-level items. I.R.C. §§ 6221, 6230(c)(4). In this regard, the Code is clear: these are items that must be contested before the IRS finalizes an FPAA. The district court did not err by concluding that it could not consider Krause's refund claims.
So if this decision holds, the Egan family might be able to appeal the Fidelity decision, but they won't get to have a fresh hearing on the penalties when they are assessed against the individual returns.
There is an old joke about a CPA who used to come to work everyday, open his desk drawer and look at a slip of paper. After he retired someone found the slip of paper and saw written on it "Debits by the Window - Credits by the Door". If he went to law school and started doing Son of BOSS deals, he would have had to change it to something more in line with the title of this post.
My readers, who may well number in the scores, vary in their degree of tax geekiness. Those of you who come here out of friendship or because I have grovelled may want to just click on a few ads and move on, because this is one of those points that is a stretch for me. I feel I must comment on this synchronicity. My last two posts have been about Fidelity International Currency. The rather long decision was issued in May. It disallowed two partnerships which had been used by EMC founder Richard Egan to shelter capital gains from the sale of stock and ordinary income from the exercise of non-qualified options.
The decision was amended on October 6 to indicate that penalties would apply. Talk about waiting for the other shoe to drop. The Egans had already put up the 60 million or so in tax. Somehow I doubt they had been counting on the refund they were suing for to do their Christmas shopping. So the October 6 amendment might be what they were really sweating out. If the judge had wanted to make life even more difficult he would have waited until January. Mr. Egan died in August 2009 making the extended due date of his estate tax return fairly imminent. Presumably the penalty will go in as a debt of the estate.
In my post I indicated that since this was a partnership case, I was leaving it to the tax litigators as to whether that really was the venue for deciding individual penalties. Next time I take a break from October 15 returns and start crawling through decisions I find the case of J. Winston Krause. Mr. Krause was a tax attorney and CPA who built his own Son of BOSS shelter. I have to wonder if he has two sides to his personality. Right now the CPA side is yelling "Language of 752, language of 752 - I knew it couldn't work. The entry didn't balance. You can't get all that basis without crediting something." The tax attorney side has answers. I can show you an example of a CPA making beautifully balanced entries that make no impression on judges, who are lawyers.
Mr. Krause's partnership did not fight the disallowance of the Son of BOSS losses. He paid the assessed tax, penalty and interest and then sued for refund of the penalties. Mr. Krause, not being a high tech billionaire. "only" has about $112,000 in penalties. (I have a rule that the word "only" should not be used in connection with sums of money greater than four dollars, but I'm relaxing it in light of the Egan's 20 million plus penalty). In arriving at its ruling he court goes into a discussion on the partnership provisions of TEFRA. (Tax Equity and Fiscal Responsibility Act of 1982). The partnership provisions of TEFRA are a more subtle part of the war against tax shelters than passive activity loss rules of the Tax Reform Act of 1986. Without them each parter in a partnership could litigate the same transactions in tax court.
To avoid duplicative litigation stemming from the tax treatment of partnerships, Congress enacted TEFRA, which creates a unified procedure for determining the treatment of partnership tax transactions. TEFRA requires the differentiation between the tax treatment of partnership-level and partner-level items.Id . § 6221. Partnership items include all items of “income, gain, loss, deduction, or credit of the partnership,” along with “optional adjustments to the basis of partnership property pursuant to an election under section 754,” and “the accounting practices and the legal and factual determinations that underlie the determination of... items of income, credit, gain, loss, deduction, etc.”
The penalties assessed under the FPAA were directly attributable to the fraudulent $2.79 million loss KAAS alleged it incurred when it sold its Canadian currency. This loss, which passed through to Krause Holdings and then to Krause, occurred because of the overstated basis KAAS had claimed in the Canadian currency due to an earlier basis election. Thus, the penalty related to basis, basis adjustments, and losses, all of which are considered partnership items under § 6231
Further, the refund sought by Krause relates to penalties and penalty-related interest that are associated with partnership-level items, both of which are in and of themselves considered partnership-level items. I.R.C. §§ 6221, 6230(c)(4). In this regard, the Code is clear: these are items that must be contested before the IRS finalizes an FPAA. The district court did not err by concluding that it could not consider Krause's refund claims.
So if this decision holds, the Egan family might be able to appeal the Fidelity decision, but they won't get to have a fresh hearing on the penalties when they are assessed against the individual returns.
Friday, October 15, 2010
Welcome to the Sausage Factory - RTFI
It's always a disappointment to me when something I get excited about turns out to be old news. Such was the case with Fidelity International Currency which was the topic of Wednesday's post. The decision, issued October 6 was an amendment of a decision issued in May. I must admit that I have not done a word for word comparison. but skipping to the end I found that in the section headed "The Court does not reach the following issues":
(4.) Whether specific accuracy-related penalties should be assessed against any member or partner of Fidelity High Tech or Fidelity International
was dropped in the amended finding.
In the conclusion section we find added
(6.) The following accuracy-related penalties are applicable to any understatement of the income tax liability of Richard Egan arising from the treatment of the Fidelity High Tech and Fidelity International transactions on the tax returns of those entities for the years 2001 and 2002.
(a.) a 40% penalty for gross valuation misstatement pursuant to § 6662(a), (b)(3), and (h);
(b.) a 20% penalty for substantial valuation misstatement pursuant to § 6662(a) and (b)(3);
(c.) a 20% penalty for substantial understatement of income tax pursuant to § 6662(a), (b)(2), and (d)(2)(A); and
(d.) a 20% penalty for negligence or disregard of rules and regulations pursuant to § 6662(a) and (b)(1).
The penalties are alternatively, and not cumulatively, applied
There are some complex court jurisdiction issues in this case, which don't interest me an awful lot. The Egans put up the estimated amount of tax that would be assessed if the partnership determination was upheld rather than go to Tax Court. The penalties discussed above are not the partnership's penalties. So I suppose there is some question as to whether the court is supposed to be ruling on them, particularly since they are not yet assessed. Whether Mr. Egan's executors can go to tax court over the penalties is a question for the tax litigators.
The two primary emotions I experience in my wanderings through the ever expanding body of primary source tax documents are compassion and schadenfreude (Curious that you have to go to German for that term.) Mr. Egan certainly doesn't need my compassion, but I do think it is sad that he was vilified in the media as a tax cheat in the final year of a life of high achievement. I think it would be tasteless and unprofessional to express schadenfreude with respect to any of the professionals involved in this debacle. I will, however, single out one for a special type of compassion. It is the "There, but for the grace of God, go I" variety of compassion. You see there is not very far distant alternate reality in which the Egans upset with their maltreatment by KPMG decide that leaving the warm embrace of a well established regional firm like O'Connon and Drew was a mistake. Maybe there are some other firms in their region of similar size to O'Connor and Drew with somebody who knows about partnerships and tax shelters. In that dystopia, the odds that this nightmare could have ended up on my desk are far from remote. Thankfully, the Egans decided to stay national. So my sympathy goes to Ron Wainwright of RSM McGladrey who got to sign the returns that KPMG wouldn't sign without disclosures that the tax attorneys said were not required.
In my previous post on this issue I analogized the people in the national firms who believed tax shelters still worked to isolated detachments of Japanese soldiers who were probably more prevalent in TV sitcoms than in real life in the fifties and sixties. Implicit in this analogy is analogizing the Tax Reform Act of 1986 to the atomic bomb. This may seem irreverent, but what can I say it's a metaphor. And it is a pretty good one because tax shelters had already been dealt very heavy blows and might have went down anyway. So in this elaborate metaphor Section 465, the at-risk rules, plays the role of ComSubPac, which sunk all the Japanese merchant ships.
At any rate to explain my own role in the world of tax shelters in similar terms it is necessary to switch sides. In this metaphor the Tax Reform Act of 1986 is the blitzkrieg. My part of the tax shelter world, low income housing, was like Vichy France. Our deals that were still in their pay in period were granted transitional relief. Somebody told me that the fiscal trade-off for that was fiscal years for S corporations. Not a good trade from my viewpoint. We got a whole new credit, which meant all the new deals had to be redesigned and kept on trucking. People capitalizing low income housing without much upside beyond the tax benefits was the way thing's were supposed to be. This particular metaphor really sucks because it makes the national guys the Maquis and me, well never mind its a metaphor. Basically we had to learn all the aggravating stuff in the 704(b) regulations and whatever other collateral damage the war against tax shelters did to Subchapter K, but we didn't have to hide in the woods while we were preparing returns.
I experienced this difference in world views in the mid-nineties when I was on the AICPA Tax Division's Partnership committee. (Hey it really impressed somebody on our peer review team once). When discussing some particularly arcane regulation a couple of the national guys indicated that they would be just as pleased if it stayed unclear. I must say that was exceptional. Generally the committee was striving for clearer regulations. I also remember that the anti- abuse regulations (1.701-2) were more or less hot off the presses at the time of our meeting. There were a lot of bent out of shape people. I, on the other hand, just looked at example 6 Special allocations; nonrecourse financing; low-income housing credit; use of partnership consistent with the intent of subchapter K and decided that there was nothing to worry about.
The Fidelity opinion got into the real nitty gritty of return preparation. The transaction I explained in my previous post was executed by a partnership called Fidelity High Tech. There were three partnership returns covering two years. The reason for the extra return was that the plan required a "technical termination" meaning that a change in ownership created a new partnership for income tax purposes. The "new partnership" was able to apply basis created by what a simple minded accountant like myself would see as an unbalanced entry to EMC stock the Egans had contributed to the partnership. In a nice bit of presentation work, they got Mellon Bank to present a capital gain (loss) schedule which incorporated the new basis. That can be a real challenge. The court mentions that they didn't file form 8275, but they had an opinion that there transaction was somehow different. What I see as the real "gotcha" is this:
Because Fidelity High Tech did not use cash cost to compute the stepped-up basis, it was required to attach an explanation to Schedule D. No such explanation was attached. An adequate explanation, as required by the instructions, would have included disclosure of the underlying transaction that resulted in the purported stepped-up tax basis used by Fidelity High Tech.
Back in the good old days, when we did returns by hand, my favorite review note was. RTFI - Read The Instructions. I really think that if I had been sweating this return out, I would have caught that. There would have been some sort of explanation. Likely it would not have been sufficient, but if you look at the revenue procedures on adequate disclosure (e.g. Rev Proc 2010-15), sometimes thoroughly filling out the form is what does the trick.
(4.) Whether specific accuracy-related penalties should be assessed against any member or partner of Fidelity High Tech or Fidelity International
was dropped in the amended finding.
In the conclusion section we find added
(6.) The following accuracy-related penalties are applicable to any understatement of the income tax liability of Richard Egan arising from the treatment of the Fidelity High Tech and Fidelity International transactions on the tax returns of those entities for the years 2001 and 2002.
(a.) a 40% penalty for gross valuation misstatement pursuant to § 6662(a), (b)(3), and (h);
(b.) a 20% penalty for substantial valuation misstatement pursuant to § 6662(a) and (b)(3);
(c.) a 20% penalty for substantial understatement of income tax pursuant to § 6662(a), (b)(2), and (d)(2)(A); and
(d.) a 20% penalty for negligence or disregard of rules and regulations pursuant to § 6662(a) and (b)(1).
The penalties are alternatively, and not cumulatively, applied
There are some complex court jurisdiction issues in this case, which don't interest me an awful lot. The Egans put up the estimated amount of tax that would be assessed if the partnership determination was upheld rather than go to Tax Court. The penalties discussed above are not the partnership's penalties. So I suppose there is some question as to whether the court is supposed to be ruling on them, particularly since they are not yet assessed. Whether Mr. Egan's executors can go to tax court over the penalties is a question for the tax litigators.
The two primary emotions I experience in my wanderings through the ever expanding body of primary source tax documents are compassion and schadenfreude (Curious that you have to go to German for that term.) Mr. Egan certainly doesn't need my compassion, but I do think it is sad that he was vilified in the media as a tax cheat in the final year of a life of high achievement. I think it would be tasteless and unprofessional to express schadenfreude with respect to any of the professionals involved in this debacle. I will, however, single out one for a special type of compassion. It is the "There, but for the grace of God, go I" variety of compassion. You see there is not very far distant alternate reality in which the Egans upset with their maltreatment by KPMG decide that leaving the warm embrace of a well established regional firm like O'Connon and Drew was a mistake. Maybe there are some other firms in their region of similar size to O'Connor and Drew with somebody who knows about partnerships and tax shelters. In that dystopia, the odds that this nightmare could have ended up on my desk are far from remote. Thankfully, the Egans decided to stay national. So my sympathy goes to Ron Wainwright of RSM McGladrey who got to sign the returns that KPMG wouldn't sign without disclosures that the tax attorneys said were not required.
In my previous post on this issue I analogized the people in the national firms who believed tax shelters still worked to isolated detachments of Japanese soldiers who were probably more prevalent in TV sitcoms than in real life in the fifties and sixties. Implicit in this analogy is analogizing the Tax Reform Act of 1986 to the atomic bomb. This may seem irreverent, but what can I say it's a metaphor. And it is a pretty good one because tax shelters had already been dealt very heavy blows and might have went down anyway. So in this elaborate metaphor Section 465, the at-risk rules, plays the role of ComSubPac, which sunk all the Japanese merchant ships.
At any rate to explain my own role in the world of tax shelters in similar terms it is necessary to switch sides. In this metaphor the Tax Reform Act of 1986 is the blitzkrieg. My part of the tax shelter world, low income housing, was like Vichy France. Our deals that were still in their pay in period were granted transitional relief. Somebody told me that the fiscal trade-off for that was fiscal years for S corporations. Not a good trade from my viewpoint. We got a whole new credit, which meant all the new deals had to be redesigned and kept on trucking. People capitalizing low income housing without much upside beyond the tax benefits was the way thing's were supposed to be. This particular metaphor really sucks because it makes the national guys the Maquis and me, well never mind its a metaphor. Basically we had to learn all the aggravating stuff in the 704(b) regulations and whatever other collateral damage the war against tax shelters did to Subchapter K, but we didn't have to hide in the woods while we were preparing returns.
I experienced this difference in world views in the mid-nineties when I was on the AICPA Tax Division's Partnership committee. (Hey it really impressed somebody on our peer review team once). When discussing some particularly arcane regulation a couple of the national guys indicated that they would be just as pleased if it stayed unclear. I must say that was exceptional. Generally the committee was striving for clearer regulations. I also remember that the anti- abuse regulations (1.701-2) were more or less hot off the presses at the time of our meeting. There were a lot of bent out of shape people. I, on the other hand, just looked at example 6 Special allocations; nonrecourse financing; low-income housing credit; use of partnership consistent with the intent of subchapter K and decided that there was nothing to worry about.
The Fidelity opinion got into the real nitty gritty of return preparation. The transaction I explained in my previous post was executed by a partnership called Fidelity High Tech. There were three partnership returns covering two years. The reason for the extra return was that the plan required a "technical termination" meaning that a change in ownership created a new partnership for income tax purposes. The "new partnership" was able to apply basis created by what a simple minded accountant like myself would see as an unbalanced entry to EMC stock the Egans had contributed to the partnership. In a nice bit of presentation work, they got Mellon Bank to present a capital gain (loss) schedule which incorporated the new basis. That can be a real challenge. The court mentions that they didn't file form 8275, but they had an opinion that there transaction was somehow different. What I see as the real "gotcha" is this:
Because Fidelity High Tech did not use cash cost to compute the stepped-up basis, it was required to attach an explanation to Schedule D. No such explanation was attached. An adequate explanation, as required by the instructions, would have included disclosure of the underlying transaction that resulted in the purported stepped-up tax basis used by Fidelity High Tech.
Back in the good old days, when we did returns by hand, my favorite review note was. RTFI - Read The Instructions. I really think that if I had been sweating this return out, I would have caught that. There would have been some sort of explanation. Likely it would not have been sufficient, but if you look at the revenue procedures on adequate disclosure (e.g. Rev Proc 2010-15), sometimes thoroughly filling out the form is what does the trick.
Wednesday, October 13, 2010
It's Over
FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC, by the Tax Matters Partner, Plaintiff, v. UNITED STATES of AMERICA
For some time, I have been of the belief that the Tax Reform Act of 1986 killed tax shelters. I'm still pretty much of that opinion. When I find a case like Fidelity International Currency Advisors A Fund, LLC, which was just issued by the US District Court for Massachusetts last week (amending their previous May findings in the case), I'm reminded of a trope that would pop up on television series in the 1950's and 1960's. One or more Japanese soldiers on a remote island have to be convinced that they have lost the war and can go home now. Gilligan and the Skipper had to deal with the problem in Episode 16 and Ensign O'Toole and the Appleby ran into it in Episode 6.
Fidelity International has local gossip value too it I guess, but not because it has anything to do with the Boston firm that runs mutual funds. The name is not a coincidence either, but that's part of the story. The tax matters partner of Fidelity was Richard Egan, recently deceased. He was one of the founders of EMC, which has its headquarters in Hopkington, MA. He was also the US Ambassador to Ireland, which, is in part, what led to this drama.
This case will likely merit more than one post. Actually there are probably a couple of good novels in there, but for now I will explain one of the transactions and comment on the feature I find most intriguing. Mr. Egan owned approximately 25 million shares of EMC, which traded at over $100 per share (Back then at the dawn of the millennium it was a well established law of nature that EMC stock could only go up). His basis was approximately two cents per share. Given that he founded a company noted for memory storage, it would have not been reasonable to try invoking the Steve Martin Rule (That is not pay the tax and say "I forgot"). So he and his son Michael, who ran his family office, consulted with an attorney and some national firms. They wanted to find a way to eliminate capital gains and also shelter the income from the exercise of non-qualified stock options. In this post I will comment only on the former.
The plan for eliminating capital gains works like this. You write a very large option which entitles you to receive a large premium. You use that premium to buy a very similar option. When it unwinds you will most likely have a loss, particularly after fees, but not a very large loss relative to the notional amount of the options. Get ready for the magic and if you are passionately attached to double entry remain calm. Form a partnership and contribute these two contracts to the partnership. Slowly. Carefully. One at a time. First there is that option you bought for say 150,000,000 (Never mind where you got it from). That's easy. Your basis is 150,000,000, the partnerships basis in it is 150,000,000. Increase your basis in your partnership interest by 150,000,000. You probably want to take a break. Now you've got that other thing. The option that you wrote. Well you got a lot of money and it seems like it could require you to pay out a lot of money. In some ways it seems like a liability. But remember this is a partnership. You need to check Section 752. Well something that you maybe have to pay isn't going to pass muster as a liability under 752. So now you are done. Your basis in your partnership interest is 150,000,000.
Now you put in your stock in Bigco which is worth 150,000,000 and has effectively zero basis. After those options sort themselves out for some relatively negligible effect, you are ready for your next step. You contribute your partnership interest into an LLC and make a 754 election. You now have to allocate your basis in your partnership interest among the assets of the technically new partnership. Your basis is still 150,000,000 and the only thing to allocate it to is the Bigco stock. So now your partnership has basis in your Bigco stock. It can sell it at a small gain or no gain or, as worked out in this case, a loss. Mr. Egan's minions needed to put more and more EMC stock into the partnership to take advantage of all the shelter they had bought as the price of EMC collapsed.
There is something really really neat about this plan that I couldn't emphasize if I was presenting it to you as a client. You see I am a member of the American Institute of Certified Public Accountants and thereby subject to its Statements on Standards for Tax Service, which were issued around the turn of the millennium. Among the things I can't do is recommend a tax position that "Exploits the audit selection process of a taxing authority." But since you and I are just pals and I am certainly not recommending this position I can tell you the really neat thing about it. If it works as planned, you never have to put a really big ugly looking negative number anywhere on any return you file. The basis that you created, as if by magic, enters into computing the gain or loss on your sale of Bigco stock. If Bigco stock behaves like everybody thought EMC stock was going to behave it means you will be reporting a gain. Just not as big a gain. No tax shelter here just a hard working high tech billionaire paying more taxes than most people.
The only thing wrong with the plan is that creating basis out of thin air doesn't even make good nonsense.
This brings me to the part of the case I find most interesting. The low reporting profile of the transaction was a big attraction. What amazes me is how big a paper trail the advisers created discussing the low reporting profile of the transaction. Stephanie Denby, an attorney, wrote in a memo to Mr. Egan:
. The IRS is certainly aware that these transactions are out there. They have implemented new reporting requirements to try to stop these transactions. To date new reporting requirements have focused solely on C corporations. Although, they could have easily applied similar restrictions to individuals, they have failed to do so.
These transactions clearly take advantage of “loopholes.” The reporting is consistent with tax law although the results are unintended. The promoters will provide tax opinion letters to avoid penalties if audited. It appears that there is a very low chance that these transactions would ever be picked up by the IRS. The promoters I have talked to have not had any audits
You see that's the neat part that I couldn't use to recommend the deal.
She also investigated insurance for the plan then sent an e-mail to James Reiss, CFO of Carruth Associates, Mr Egan's family office :
Fidelity International has local gossip value too it I guess, but not because it has anything to do with the Boston firm that runs mutual funds. The name is not a coincidence either, but that's part of the story. The tax matters partner of Fidelity was Richard Egan, recently deceased. He was one of the founders of EMC, which has its headquarters in Hopkington, MA. He was also the US Ambassador to Ireland, which, is in part, what led to this drama.
This case will likely merit more than one post. Actually there are probably a couple of good novels in there, but for now I will explain one of the transactions and comment on the feature I find most intriguing. Mr. Egan owned approximately 25 million shares of EMC, which traded at over $100 per share (Back then at the dawn of the millennium it was a well established law of nature that EMC stock could only go up). His basis was approximately two cents per share. Given that he founded a company noted for memory storage, it would have not been reasonable to try invoking the Steve Martin Rule (That is not pay the tax and say "I forgot"). So he and his son Michael, who ran his family office, consulted with an attorney and some national firms. They wanted to find a way to eliminate capital gains and also shelter the income from the exercise of non-qualified stock options. In this post I will comment only on the former.
The plan for eliminating capital gains works like this. You write a very large option which entitles you to receive a large premium. You use that premium to buy a very similar option. When it unwinds you will most likely have a loss, particularly after fees, but not a very large loss relative to the notional amount of the options. Get ready for the magic and if you are passionately attached to double entry remain calm. Form a partnership and contribute these two contracts to the partnership. Slowly. Carefully. One at a time. First there is that option you bought for say 150,000,000 (Never mind where you got it from). That's easy. Your basis is 150,000,000, the partnerships basis in it is 150,000,000. Increase your basis in your partnership interest by 150,000,000. You probably want to take a break. Now you've got that other thing. The option that you wrote. Well you got a lot of money and it seems like it could require you to pay out a lot of money. In some ways it seems like a liability. But remember this is a partnership. You need to check Section 752. Well something that you maybe have to pay isn't going to pass muster as a liability under 752. So now you are done. Your basis in your partnership interest is 150,000,000.
Now you put in your stock in Bigco which is worth 150,000,000 and has effectively zero basis. After those options sort themselves out for some relatively negligible effect, you are ready for your next step. You contribute your partnership interest into an LLC and make a 754 election. You now have to allocate your basis in your partnership interest among the assets of the technically new partnership. Your basis is still 150,000,000 and the only thing to allocate it to is the Bigco stock. So now your partnership has basis in your Bigco stock. It can sell it at a small gain or no gain or, as worked out in this case, a loss. Mr. Egan's minions needed to put more and more EMC stock into the partnership to take advantage of all the shelter they had bought as the price of EMC collapsed.
There is something really really neat about this plan that I couldn't emphasize if I was presenting it to you as a client. You see I am a member of the American Institute of Certified Public Accountants and thereby subject to its Statements on Standards for Tax Service, which were issued around the turn of the millennium. Among the things I can't do is recommend a tax position that "Exploits the audit selection process of a taxing authority." But since you and I are just pals and I am certainly not recommending this position I can tell you the really neat thing about it. If it works as planned, you never have to put a really big ugly looking negative number anywhere on any return you file. The basis that you created, as if by magic, enters into computing the gain or loss on your sale of Bigco stock. If Bigco stock behaves like everybody thought EMC stock was going to behave it means you will be reporting a gain. Just not as big a gain. No tax shelter here just a hard working high tech billionaire paying more taxes than most people.
The only thing wrong with the plan is that creating basis out of thin air doesn't even make good nonsense.
This brings me to the part of the case I find most interesting. The low reporting profile of the transaction was a big attraction. What amazes me is how big a paper trail the advisers created discussing the low reporting profile of the transaction. Stephanie Denby, an attorney, wrote in a memo to Mr. Egan:
. The IRS is certainly aware that these transactions are out there. They have implemented new reporting requirements to try to stop these transactions. To date new reporting requirements have focused solely on C corporations. Although, they could have easily applied similar restrictions to individuals, they have failed to do so.
These transactions clearly take advantage of “loopholes.” The reporting is consistent with tax law although the results are unintended. The promoters will provide tax opinion letters to avoid penalties if audited. It appears that there is a very low chance that these transactions would ever be picked up by the IRS. The promoters I have talked to have not had any audits
Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more discrete [sic] and less likely I believe to cross the IRS radar screen.
You see that's the neat part that I couldn't use to recommend the deal.
She also investigated insurance for the plan then sent an e-mail to James Reiss, CFO of Carruth Associates, Mr Egan's family office :
Marsh &; McLennan does not issue insurance for “transactions with no economic purpose other than the tax benefits.” I think if we pursue this and get rejected, we would be creating a bad trail. Accordingly, I think this is not something to pursue. Let me know if you agree.
Mr. Reiss responded
They probably help insure “straight” transactions. What fun is there to that? I agree with your comment.
The search went on. Eventually Ms. Denby prepared a comparison of various methods being promoted by national firms rating them positively or negatively based on various attributes including :
Denby also rated and commented with respect to the manner in which the tax loss was generated, noting a plus if the transaction was “harder for [the] IRS to find” and a minus if the transaction was “easier” for the IRS to find
Denby also rated and commented with respect to their complexity, noting a plus if the complexity of the structure made it harder for the IRS to “unwind” or “pick-up” and a minus if the simplicity of the structure made it easier for the IRS to trace.
Ultimately they went with a plan being promoted by KPMG. As part of the deal KPMG would prepare the returns. Unfortunately, the landscape shifted between the time of the committment to the transactions and the filing of the affected returns. KPMG decided that the transactions did need to be explicitly disclosed. This was upsetting:
On August 30, 2002, Stephanie Denby sent Reiss and Shea a proposed draft letter to Tim Speiss at KPMG. (Ex. 3429). The letter stated that Denby was “astonished” that KPMG would not sign the tax return without a disclosure statement, and that she found the firm's position “shocking” and “untenable,” as well as “a breach of KPMG's fiduciary duty and patently unprofessional.” In her cover e-mail, she wrote that “it would make sense to send out [the letter] after we have confirmation that [Speiss] has purged his files.”
So they fired KPMG and got McGladrey to prepare the returns. I have never seen a case go into as much detail on the minutiae of return preparation. I'm hoping to write more on it in the weeks to come.
The end result of the case was to blow up the transaction and subject it to a 40% gross overstatement penalty. All the lesser 20% penalites were also found applicable, but they are not cummulative. The letters from attorneys saying that positions were reasonable and disclosure was not required were of no avail.
When this case was announced in the media earlier this year there was some villification of Mr. Egan, which I really think was misplaced. Mr. Egan was part of the team of people that helped put men on the moon. His team of adivsers believed that there were geniuses in the national firms that had figured out a legitimate capital gain strategy. In retropsect, it is easy to say that they should have realized the game was up when KPMG told them they had to disclose. That was like the real life case of Second Lieutenant Hiroo Onoda on Lubang Island in the Philliphines. When his former commander Major Taniguchi told him the war was over he came out of the jungle with his rifle, 500 rounds of ammo and some hand grenades. It was 1974. He was lucky not to have a letter from a law firm to contradict him.
So they fired KPMG and got McGladrey to prepare the returns. I have never seen a case go into as much detail on the minutiae of return preparation. I'm hoping to write more on it in the weeks to come.
The end result of the case was to blow up the transaction and subject it to a 40% gross overstatement penalty. All the lesser 20% penalites were also found applicable, but they are not cummulative. The letters from attorneys saying that positions were reasonable and disclosure was not required were of no avail.
When this case was announced in the media earlier this year there was some villification of Mr. Egan, which I really think was misplaced. Mr. Egan was part of the team of people that helped put men on the moon. His team of adivsers believed that there were geniuses in the national firms that had figured out a legitimate capital gain strategy. In retropsect, it is easy to say that they should have realized the game was up when KPMG told them they had to disclose. That was like the real life case of Second Lieutenant Hiroo Onoda on Lubang Island in the Philliphines. When his former commander Major Taniguchi told him the war was over he came out of the jungle with his rifle, 500 rounds of ammo and some hand grenades. It was 1974. He was lucky not to have a letter from a law firm to contradict him.
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