RICO Claim Dismissed Against Bullshit Tax Shelter Promoters (11/22/19)

Note: This is posting to the Tax Procedure Blog of an earlier posting on my Federal Tax Crimes Blog, that I decided to copy and post here because relevant to tax procedure issue.

In Menzies v. Seyfarth Shaw LLP, __ F.3d ___ (7th Cir. 2019), here, the Court dismissed a RICO claim arising out of an alleged fraudulent tax shelter peddled to the taxpayer (Menzies) by a lawyer, law firm and two financial services firms.  The Court held that fraudulent tax shelters can be subject of RICO claims, but Menzies had failed to properly assert the claims in the pleadings.

The particular shelter involved was of the bullshit shelters, often a topic discussed on this blog.  Here is my definition from my Tax Procedure books (Practitioner Edition p. 905 (footnotes omitted); Student Edition p. 616):

Abusive tax shelters are many and varied.  Some are outright fraudulent, usually wrapped in a shroud of paper work and cascade of words designed to mask 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 IRS auditors, if they stumble across the transaction(s)) 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, offer a favorable cost benefit/ratio only because of the tax benefits to be offered by the audit lottery, (iv) the promoters (and other enablers) 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 potential penalty risks by shifting them 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.”  Others have described the abusive tax shelters as “too good to be true.” 

I could not ascertain precisely what the steps in the fraudulent tax shelter scheme were other than, like Son-of-Boss transactions, the scheme created artificial losses that, presumably, offset the gain on sale of AUI stock, although it is not clear whether that gain was ever reported in order to use artificial losses. (I perhaps just missed something there.)  Here is the best explanation from Judge Hamilton’s dissenting opinion (Slip Op. 33-35):

A. The Fraudulent Scheme 

Attorney Graham Taylor (later convicted for another tax fraud) and other attorneys at Seyfarth Shaw teamed up with bankers from Euram Bank (The European American Investment Bank), Northern Trust Corporation, and later Christiana Bank to devise a fraudulent scheme for concealing a taxpayer’s receipt of a large capital gain. The defendants pitched the scheme to Menzies, his business partner Ferenc, and others. 

The scheme involved a series of carefully designed paper transactions among the taxpayer, the banks, and nominally independent trusts established on the defendants’ instructions, all blessed with fraudulent legal opinion letters. The strategy took several years to set up and execute just for Menzies himself, beginning about three years before he actually sold his stock in AUI to Berkshire Hathaway.   

The complaint describes the scheme in great detail. A brief description of the “Euram Oak Strategy,” must be incomplete but can help show its complexity and why plaintiff characterizes the scheme as a “product” that defendants used at least several times and threatened to continue to repeat.  

The scheme used a network of trusts and a dizzying array of sham transactions to disguise the ownership of AUI stock and to enable Menzies to obscure a large capital gain upon the eventual sale of the stock. See Second Amended Cplt. (SAC) ¶¶ 65–97 (detailing the 2003 and 2004 transactions). Menzies began to execute defendants’ fraudulent “Euram Oak Strategy” in 2003. First, defendants had him borrow $19 million from Euram and deposit those funds in another Euram account in the name of a trust that the defendants had just set up for him. SAC ¶ 74. The trust reinvested the proceeds with Euram itself, in return for a promissory note. The defendants then set up another trust for Menzies and orchestrated a series of sham transactions among Menzies and the trusts. SAC ¶ 79. 

Menzies then swapped assets with the original trust, accepting the Euram promissory note in exchange for an equal value of AUI stock, and used the note to pay off his original loan obligation. SAC ¶¶ 83–85. After another series of transactions involving the movement of assets and the termination of the first trust, the second trust held $19 million of AUI stock and owed Menzies $19 million. SAC ¶ 90. 

Throughout all of this, the funds from the original loan never left Euram. In 2004, the defendants led Menzies through another series of similar transactions with a new $54 million loan from Euram. SAC ¶¶ 95–96. After these transactions, another $54 million of AUI stock was in the second trust, with a corresponding obligation from the trust to Menzies.  

The payoff came in 2006, when Menzies and Ferenc agreed to sell their business to Berkshire Hathaway. As part of the deal, Berkshire Hathaway paid the remaining trust more than $64 million for the shares that Menzies had placed there. SAC ¶ 132. The trust then used the proceeds from the sale to repay Menzies the amount it owed him.  

Pursuant to advice from the defendants, when Menzies filed his 2006 tax return, he did not report his capital gain of more than $44 million. SAC ¶ 143. In 2009, the IRS began an audit of Menzies, finding that the key transfers of stock were not arms-length transactions and that the scheme constituted an abusive tax shelter SAC ¶¶ 138–40. In 2012, Menzies settled with the IRS, paying $6.7 million in capital gains tax, $1.3 million in penalties, and $2.4 million in interest. 

JAT Comments:

1. I did not get into the merits of the RICO and related claims.  That is beyond my expertise and some expertise is required to summarize the discussions in the majority and dissenting opinions.

2. I just wanted to call out the bullshit tax shelter.  It seems to me that, in reporting the “benefits” of the fraudulent scheme, the artificial losses would have to be paired with the real economic gain on sale of the AUI stock.  But, the majority says “Nowhere in his 2006 federal income tax return did Menzies report the sale or any related capital gains. Nor did Christiana Bank, which filed tax returns on behalf of Menzies’s trusts, report any taxable income from the stock sale.” (Slip Op. 3-4.)

3. I am still amazed at how pervasive marketed cookie-cutter bullshit tax shelters were in the late 1990s and into the 2000s and not by marginal players (as was the case for the round of tax shelters I saw in the late 1970s and 1980s).  Big and prominent professional firms (lawyers and CPAs) and financial institutions were lured into the game by “value added” fees which were somehow tied to the amount of tax saved (more properly, evaded).  In effect, those firms were selling the taxpayers criminal and civil penalty insurance for the fraudulent transactions and charging outsized fees (premiums) for the insurance.  And, as many courts have said when looking at taxpayer penalties, the taxpayers usually highly sophisticated knew that making outsized gains disappear was too good to be true.  I always thought the IRS had a criminal case against at least some of the taxpayers involved trying to hide behind their professionals, for they usually had to make a lie as the centerpiece for the whole deal -- that they had bona fide business or investment profit reasons for the deal rather than the claimed tax benefits.  In most cases, that was not a truthful statement and most tax fraud and other fraud (e.g., securities fraud) it is all about the lie that a jury can understand.  (In the Enron criminal fraud, the prosecutor said the case was not about accounting principles that Enron sought to hide behind, but about lying, cheating and stealing.)  Juries get that.

4. And, by extension, if there is fraud, the partnership's or individual partners' civil statute of limitations may be open for six years or even forever.  The partnership statutes of limitations are minimum statutes of limitations, so that a partner's statute of limitations can allow adjustments even if the partnership's statute of limitations has closed.  Thus, for example, if the partnership return is fraudulent the statute is 6 years as to all partners and forever and forever as to partners partners signing or participating in the preparation of the return.  And, if the partner's individual statute of limitations under § 6501 is open (e.g., for for fraud under § 6501(c)(1)), partnership item adjustments can be made for that partner at any time.  (This presents the issue of whether the mere reporting of fraudulent items on a partner level return can permit the unlimited § 6501(c)(1) statute without respect to the partner's personal fraud as to which the courts are in conflict.  Compare Allen v. Commissioner, 128 T.C. 37 (2007) (taxpayer’s fraud not required); and BASR Partnership et al. v. United States, 795 F.3d 1338 (Fed. Cir. 2015) (taxpayer’s fraud required); and see City Wide Transit, Inc. v. Commissioner, 709 F.3d 102, 107 (2d Cir. 2013) (Allen makes “intuitive sense”).  Thus, even setting aside the Allen/BASR issue, if the partner is the one giving the false statement as to investment or business motive (the putative nontax motive) for the bullshit transaction, the IRS would appear to have open statutes of limitations at the partnership and partner levels, but for some reason the IRS has eschewed aggressive protection of public fisc by asserting open statutes of limitations and civil fraud penalties.  I tried to estimate at one time how much might be involved in this issue and found that, as to bullshit partnership positions already known to the IRS it was substantially in excess of $10 billion dollars.  And, here is the real kicker, those statutes are still open even if for taxpayers such as Home Concrete that have litigated the six-year statute of limitations issue.  United States v. Home Concrete, 566 U.S. 478 (2012) (six year statute does not apply to Son-of-Boss transaction).  Stated pungently, the Home Concrete (and other litigated case) tax dollars, penalties and interest and still there for the grabbing if the IRS goes for them, which I suspect it won't.  But, talk about issues with clear cost/benefit ratios, this would be one and would probably some of the best enforcement dollars the IRS ever spent.