Two Courts' Approaches to Taxpayer Culpability in the Son-of-Boss Bullshit Tax Shelter (3/26/15)

I posted this blog entry on my Federal Tax Crimes Blog, but the topic is also applicable to Federal Tax Procedure:

I write today on two recent cases that evidence different approaches to taxpayer culpability for tax underpayment from "investing" in bullshit tax shelters.  These cases are CNT Investors LLC et al. v. Commissioner, 144 T.C. No. 11 (2015), here, and Kerman v. Chenery Associates, Inc. (WD Ky NO. 3:06-CV-00338-CRS 3/23/15), here.

For context, readers will recall that the Son-of-Boss ("SOB") tax shelter and the Custom Adjustable Rate Debt Structure ("CARDS") tax shelter are variations on the theme of no-cost (except promoter fees and reams of paper and commotion) tax benefits from thin air.  They have been the basis for several  prominent criminal prosecutions.  Courts have routinely called them too good to be true.  Most courts have reached that conclusion with respect to the type of sophisticated taxpayers who entered these shelters.  All of these shelters not only involved sophisticated taxpayers but required that those sophisticated taxpayers represent to the promoter and the issuers of the legal opinions that they had a profit motive independent of the tax motive.  In the context of the tax adventure in which that representation was made (tax benefits created from nothing except paper shuffling and payment of large fees to the promoters), that representation was bullshit.  That's my opinion and probably the opinion of most courts that have dealt with the issue.  I am some readers will disagree and I welcome their comments/corrections.

So, let's turn to the cases.  First, I will discuss the Kerman case.

Kerman was a suit by a taxpayer - "investor" against promoters of the adventure.  The originally named defendants were prominent players in the bullshit shelter industry:  Chenery Associates, Inc., Chenery Management, Inc., Sussex Financial Enterprises, Inc, Sidley Austin Brown & Wood, LLP, R. J. Ruble, Roy Hahn, Bayerische Hypo-Und Vereinsbank, HVB U.S. Finance, Inc.   The HVB defendants moved for dismissal of the remaining claims against it.

The IRS had prevailed in the Kerman's Tax Court case. here, and appeal, here, which had, successively, imposed the tax and the 40% accuracy related penalty.  (I will discuss this in more detail in discussing CNT Investors.)  For my blog discussion of the appellate case, see A Self-Proclaimed "Simple Man," "Utterly Uneducated" in Tax and Finance, but Still a Self-Made Multi-Millionaire Loses his Bullshit Tax Shelter Case (Federal Tax Crimes Blog 4/13/13), here. As a result, the Kermans conceded in their suit against the HVB defendants that:  "[i]ndisputably, the[y] participated in the abusive tax-shelter in conjunction with HVB."  Seizing on that concession, "HVB now contends that this admission is fatal to the Kermans' remaining claims against it under the theory of in pari delicto."

The Kerman court opened its discussion as follows:

The common law docntrine in pari delicto is a phrase that is short for the maxim in pari delicto potior est condition defendent is, which means: "In a case of equal or mutual fault . . . the position of the [defending] party . . . is the better one." Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306, 105 S. Ct. 2622, 2626, 86 L. Ed. 2d 215 (1985) (quoting Black's Law Dictionary 711 (5th ed. 1979) (alternation in original)). When applied, it serves as a defense that prevents two parties whose wrongdoing are found to be in pari delicto from recovering from one another for any damages that arose from that joint wrongdoing. Bateman Eichler, 472 U.S. at 306, 105 S.Ct. 2622 (footnotes omitted). Courts apply the doctrine based on "two premises: first, that courts should not lend their good offices to mediating disputes among wrongdoers; and second, that denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality." See id.; see also In re Dublin Securities, Inc., 133 F.3d 377, 380 (6th Cir.1997) ("'No Court will lend its aid to a man who founds his cause of action upon an immoral or illegal act.'"). 

In one germane application of the doctrine, a Kentucky court found that when two parties participate in a tax evasion transaction, they are deemed to be in pari delicto. Eline Realty Co. v. Foeman, 252 S.W.2d 15, 19 (Ky. 1952)(citing Stacy v. Williams, 253 Ky. 353, 69 S.W.2d 697; Middlesboro Home Telephone Co., v. Louisville & N. R. Co., 214 Ky. 822, 284 S.W. 104). This is true even if the plaintiff was induced to enter the transaction. Id. Here, the Kermans' admit that "[i]ndisputably, [they] participated in the abusive CARDS tax-shelter with HVB and the other Defendants." DN 227, p. 5. Moreover, they do not even dispute that, as a result, they are in pari delicto with HVB. Id. Instead, they argue that, regardless of whether they are in pari delicto with the Defendants, the defense does not bar their claims for rescission or under KRS §446.070 in this instance. We address these arguments in turn.

In the further discussion, the Kerman court said:

The Kermans participated with HVB in a tax-evasion scheme whose "only economic consequence . . . was [a] . . . tax benefit of $1,248,876" to the Kermans. Kerman v. C.I.R., 101 T.C.M. (CCH) 1241 at *11. HVB may have aided or assisted in the preparation of the Kermans' false or fraudulent tax return, but the Kermans entered into a transaction where they were "promised something for nothing -- tax benefits without economic cost" -- and "knew or should have known that [it] was too good to be true" as a matter of "simpl[e] common sense." Kerman v. C.I.R., 713 F.3d 849, 870 (6th Cir. 2013) cert. denied, 134 S. Ct. 904, 187 L. Ed. 2d 778 (2014). The Kermans and HVB were mutual offenders. 

* * * * 

Because the Kermans have not disputed that they were in pari delicto with HVB and they have failed in their attempts to distinguish Dubord, we find that our holding in that case is dispositive of the Kermans' KRS § 446.070-based claim here. We conclude that the Kermans' "participat[ion] in the abusive CARDS tax-shelter" scheme and HVB's alleged violation KRS § 141.990 are "at once in pari delicto" and, consequently, this claim fails as a matter of law. For these reasons, we will grant HVB's motion to dismiss the Kermans' Fifth Claim.

Now, let's turn to CNT Investors in which a different approach to the taxpayer's involvement was taken.  The key issue in CNT Investors that I discuss relates to the reliance on professional as reasonable cause for escape from the accuracy related penalty.  The Tax Court easily found that the 40% substantial understatement penalty applied.  See Section 6662(h), here.  The court then turned to the reasonable cause defense in Section 6664(c), here, and the underlying regulations.  Since this was a TEFRA proceeding, the court could entertain this defense only if the actions of the general partner undertaking the adventure had the required reliance on professional.  That general partner was the taxpayer ("Carroll") ultimately getting the benefits of the SOB shelter.  That GP/taxpayer did not testify or even appear at trial.  "For mental health reasons, Mr. Carroll, now in his mid-eighties, did not testify or even appear at trial, so the Court had no opportunity to observe him firsthand or to assess his credibility.  Rather, the evidence as to his reliance was circumstantial, principally through his long-time attorney and family members.  The Court weighed the circumstantial evidence and concluded that the taxpayer had the necessary reliance on the professional.

I won't get into a detailed review of the Court's reasons.  Suffice it to say that the court's view of the circumstantial evidence it cites seems to me to be a very generous taxpayer-friendly assessment of the facts.  Nevertheless, the approaches of this judge to the evidence seems to be at odds with prior tax court cases and the court in Kerman.  Of course, the reliance on professional defense is highly factual, so I suppose that it is conceivable that a judge on the right facts could find that a wealthy taxpayer could not have realized that the creation of tax benefits whole cloth was not too good to be true.  This judge (Judge Wherry) did, and obviously since it is a T.C. opinion, it got some level of attention among the judges.  The question is whether the Government will appeal.