Before discussing the case, I offer this description of tax shelters from my Federal Tax Procedure Book (footnotes omitted):
Abusive tax shelters are many and varied. Some are outright fraudulent, usually wrapped in a shroud of paper work designed to present the shelter as a real deal. The more sophisticated are often without substance but do have some at least attenuated, if superficial, claim to legality. Some of the characteristics that I have observed for tax shelters that the Government might perceive as abusive are that (i) the transaction is outside the mainstream activity of the taxpayer, (ii) the transaction is incredibly complex in its structure and steps so that not many (including specifically IRS auditors) will have the ability, tenacity, time and resources to trace it out to its illogical conclusion (this feature is often included to increase the taxpayer’s odds of winning the audit lottery); (iii) the transaction costs of the arrangement and risks involved, even where large relative to the deal, still have a favorable cost benefit/ratio only because of the tax benefits to be offered by the audit lottery, (iv) the promoters of the adventure make a lot more than even an hourly rate even at the high end for professionals (the so-called value added fee, which is often insurance type compensation to mediate shift potential penalty risks to the tax professional or the netherworld between the taxpayer and the tax professional) and (v) the objective indications as to the taxpayer's purpose for entering the transaction are a tax savings motive rather than any type of purposive business or investment motive. More succinctly, Michael Graetz, a Yale Law Professor, has described an abusive tax shelter as “[a] deal done by very smart people that, absent tax considerations, would be very stupid.” Other thoughtful observers vary the theme, e.g. a tax shelter “is a deal done by very smart people who are pretending to be rather stupid themselves for financial gain.”Blum fits the pattern.
Mr. Blum was a very successful businessman. He was apparently very capable in assessing risks and rewards of financial ventures. Mr. Blum retained KPMG who sold him one of its tax shelter products which it marketed in the 1990s and early 2000s. This particular product was OPIS, a basis enhancement strategy. The abusive basis enhancement strategies claimed to create large amounts of basis without the taxpayer having to incur a cost for the basis. The taxpayer would then use the artificial basis to offset otherwise taxable gain, thereby artificially reducing the tax liability. Mr. Blum got into the deal when he had a large gain that would otherwise be taxed.
When KPMG's representative made the pitch, Mr. Blum "claims he saw an investment opportunity; the Commissioner claims Mr. Blum saw a tax evasion opportunity." (Emphasis supplied.) Mr. Blum bought the pitch and made a representation to KPMG that he was doing the deal for a legitimate nontax business or investment purpose. (That representation was essential to KPMG's participation in implementing the transaction.) Bottom-line, the Tax Court concluded and the Tenth Circuit concluded that the representation was false.
One twist in the case was that, in a parallel proceeding, Mr. Blum sued KPMG, alleging fraudulent misrepresentation. "After the Tax Court approved the negligent underpayment penalty, the District Court ruled that such a finding collaterally estopped Mr. Blum from arguing that he relied on KPMG's advice that OPIS was a legitimate investment strategy."
On appeal, Mr. Blum tried to distinguish his situations from the other cases -- all losses -- for such tax shelter players. He made an argument that the economic substance test must be applied as it existed at the time rather than as it has been refined over the subsequent years. He somehow had the notion that the interpretation of economic substance was sufficiently different then that, based on his facts, he should win.
The Court said no. Here is a succinct part of its analysis:
A transaction that produced enormous tax savings without concomitant losses would have triggered red flags under pre-Keeler case law. It would have smacked of a too-good-to-be-true transaction, and it would have been a "transaction lacking an appreciable effect, other than tax reduction." James, 899 F.2d at 908. In other words, the applicable case law has changed—if at all—only in minor, predictable ways, none of which would have changed the outcome of Mr. Blum's case.The Court then affirmed the Tax Court's conclusion of no objective economic substance. After analyzing and rejecting Mr. Blum's arguments on objective economic substance, the Court concludes with this:
Finally, we turn to the issue of subjective motivation and intent as it relates to objective profit potential. Of all the arguments Mr. Blum raises about the proper application of the objective economic substance analysis, this one gives us the most pause. It probably would be inappropriate for the Tax Court to let the subjective motivations of some of the players overwhelm contrary evidence about profit potential. Fortunately, the Tax Court did not let that happen. Mr. Blum points to a handful of the Tax Court's observations that, in his mind, indicate that the Tax Court neutered the objective prong by interpreting Dr. Hodder's testimony in light of KPMG's and UBS's subjective purposes behind OPIS. See, e.g., Op. 37 ("calculations assume a transaction that was not pre-ordained to create a loss intended specifically to offset a particular gain") (emphasis added). This type of reasoning is permissible, however, and does not neuter the objective prong. Indeed, the subjective motivations of parties to a transaction can help put objective evidence into context, especially in a transaction like this one that is embedded with various discretionary tools. That is to say, one party's purportedly objective evidence that a deal could result in profit may be less persuasive if another party offers evidence that the actors could influence the outcome and had a motive to do so. Importantly, the Tax Court did not reference Mr. Blum's subjective motivation in this part of its analysis; it merely looked to the subjective motivation of the parties that structured and executed the transaction to understand better the objective profit potential. Therefore the Tax Court did not err when it reconciled conflicting expert testimony in this way.The Court then turned to Mr. Blum's subject motivation -- a key component of the economic substance analysis. Mr. Blum "maintains that he participated in OPIS to make a profit, not to reduce his tax liability, and therefore the Tax Court erred in finding that the transaction lacked economic substance." The Court says (emphasis supplied):
The Tax Court didn't buy it, and neither do we. Mr. Blum's "actions during and after the OPIS transaction" indicate that his sole motive was tax avoidance. Op. 33. In particular, we note that the timing of the transaction relative to the sale of his stock, his purpose in retaining KPMG, his failure to investigate the deal's economic prospects, and his subsequent description of the transaction in his civil suit against KPMG speak volumes about his intent.The Court then goes into the gory details. Suffice it to say that the Tax Court did not believe his self-serving claims of subjective nontax intent/purpose and the Court of Appeals did not believe those claims either. (For what it is worth and from a removed perspective, I don't believe them either.)
The Court then sustained the application of the 40% gross valuation misstatement penalty which the Supreme Court had approved for this genre of basis enhancement strategies. See United States v. Woods, ___ U.S. ___ (12/3/13), here, discussed in Supreme Court Applies 40% Penalty to Bullshit Basis Enhancement Shelters (Federal Tax Crimes Blog 12/3/13), here.
The Court also sustained the Tax Court's holding on the 20% accuracy related penalty for negligence. The Court rejected his reasonable cause defense for reliance on professionals. This is the money quote:
The KPMG opinion letter that Mr. Blum signed contained statements that Mr. Blum knew or should have known were false. The advice stated that it depended on the representation that Mr. Blum had reviewed the economics of the deal and expected to earn a profit. Ex. 98 at 1, 8. He knew that he had not reviewed the economics of the deal himself, nor had he asked his advisors (other than KPMG) to do so. Mr. Blum neglected to do this despite KPMG's explicitly stating that its opinion letter was premised on an independent evaluation of the transaction. Ex. 12. Because a reasonable cause defense depends on the presence of advice not based on "inaccurate representation or assumption as to the taxpayer's purposes for entering into a transaction" that generated the disputed benefits, this misrepresentation means that Mr. Blum cannot claim the defense in this case. 26 C.F.R. § 1.6664-4(c). See 106 Ltd., 684 F.3d at 92-93; Fidelity Int'l Currency Advisor A Fund, LLC v. United States, 747 F. Supp. 2d 49, 242-44 (D. Mass. 2010).
Mr. Blum claims that the Commissioner is arguing that Mr. Blum "hoodwinked" a Big Four accounting firm. Appellant Reply 28. That is not how we interpret the Commissioner's argument. KPMG knew what it was doing. The facts we know today indicate that KPMG was the mastermind behind the tax sheltering schemes. However, just because KPMG misbehaved does not mean Mr. Blum is without fault. In particular, the reasonable cause exception requires that he prove he did not provide inaccurate information to KPMG. But, in fact, he did. KPMG may have acted nefariously, but that does not excuse Mr. Blum's negligence.In short, the Court concludes, KPMG and Mr. Blum were complicit in the transaction and the false tax claims on the original return. And, like such complicit arrangements to raid the fisc, those parties shared the benefits of their arrangement -- KPMG got outsized fees which came from the taxes the taxpayer would avoid and the taxpayer avoided reporting large capital gains. It was win-win for them until the IRS discovered it. Since then it certainly proved a disaster for KPMG as well as the taxpayers who ended up not having any tax savings -- indeed having penalties -- from the misbegotten adventure.
The Court finally dealt with Mr. Blum's lament that the Tax Court finding being affirmed would have some preclusive effect in the civil litigation.
Before concluding, we turn to Mr. Blum's concern that the Tax Court's opinion, if allowed to stand, will bar him from pursuing his civil claims against KPMG. The District Court overseeing Mr. Blum's civil case concluded that collateral estoppel prohibits Mr. Blum from arguing KPMG was negligent in preparing his taxes. See Blum v. KPMG, LLP, No. SACV 11-01885-CJC (C.D. Cal. July 17, 2012) (Order).
Ultimately it is not our place to decide whether the Tax Court's decision and our affirmance or reversal should collaterally estop Mr. Blum's claims in other courts. Furthermore, we agree with the Commissioner, in his supplemental briefing on this issue, that even if we were to affirm on more limited grounds, we could not guarantee that such a ruling would have any impact on the District Court's collateral estoppel analysis. It is worth noting, however, that the District Court did not "expressly predicat[e]" its ruling on the Tax Court's finding that OPIS lacked economic substance. Contra Appellee Supp. Br. 10. Rather the District Court pointed to both the lack of economic substance and the reasonableness of Mr. Blum's reliance on KPMG and appeared to treat these as separate issues, both of which were collaterally estopped. See, e.g., Blum, No. SACV 11-01885-CJC at *6 ("Mr. Blum is now collaterally estopped from litigating the issues of whether he believed OPIS was a legitimate investment strategy and whether he relied on KPMG's advice to that effect.").
In any event, we find that the Tax Court reached correct conclusions regarding each of the independent reasons why Mr. Blum could not prove reasonable cause to rely on KPMG for purposes of avoiding a negligent underpayment penalty. We simply note that the Tax Court's opinion on reasonable reliance and good faith appears narrowly tailored to this penalty provision. Op. 44 ("[W]e do not find that petitioners actually relied on KPMG in good faith for purposes of the reasonable cause and good faith defense to accuracy-related penalties."). In fact, the Tax Court concluded that Mr. Blum "certainly relied on KPMG, and KPMG's failures toward its client during and after the years at issue are well-documented." Id. We cannot provide an opinion about the relationship these conclusions have to the applicable law in Mr. Blum's civil case. Perhaps these issues are sufficiently similar to satisfy the prerequisites for collateral estoppel. Perhaps they are not. But that is an issue for the Central District of California or the Ninth Circuit Court of Appeals to decide. The question is not properly before this Court.Finally, given the findings that Mr. Blum misrepresented his intent and that misrepresentation was sine qua non to the deal, as I have said before in such shelters, why wasn't the civil fraud penalty asserted?