California Journal of Tax Litigation, 2013 2nd Quarter

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Newsletter of the Tax Procedure and Litigation Committee Taxation Section of the State Bar of California

In This Edition: A Special Edition Focused on Criminal Tax

Message from the Chair
By David Klasing, Esq.

“U.S. Officials Accuse IRS of Digital Espionage and Fourth Amendment Violations in Criminal Tax Investigations”
By Joseph P. Wilson, Esq.


“Recently Proposed Amendment to the Federal Sentencing Guidelines Effect Criminal Tax Cases”
By Steve Toscher, Esq. and Dennis Perez Esq.

“The Big Boys Get Better Treatment in Our Tax System Than Do Minnows”
By Jack Townsend, Esq.

“Preparing Your Client for Pre-Sentencing”
By Robert Horwitz, Esq.

“Time’s a Ticking: IRS Voluntary Classification Settlement Program (VSCP)”
By Lisa Barnett, Esq.

Recent Cases of Interest
By Robert Horwitz, Esq.

Editor’s Note

Submission Deadlines


Message from the Chair

Hello again from your current TPL chair David Klasing!

The TPL Committee Leadership would like to thank Randy Ferris, the Chief Counsel of the Legal Division, and Anthony Epolite, Tax Counsel with the Appeals Division for a great presentation delivered during the TPL Committee’s last meeting on February 1, 2013, at the State Board of Equalization Headquarters in Sacramento.

We also wish to thank those members of the Committee at large who have volunteered to write and present for the Washington and Sacramento Delegations, draft and submit articles and Quick points for our Committee Newsletter and for the California Tax Lawyer Magazine, who have offered suggestions on programs for the 2013 Annual Tax Bar Meeting and who are developing webinars.

TPL Sponsored Topics for the 2013 Annual Tax Bar Meeting

We hope that everyone is planning to attend the 2013 Annual Tax Bar Meeting. Our Committee has submitted for sponsorship and co-sponsorship the following programs that have been approved by the Executive Tax Committee.

Who Has Your Information? – A review of information sharing programs in effect between California state tax authorities (FTB, BOE and EDD), state agencies, and federal and state government. The presentation will also explore information sharing as relevant to litigation and audit strategies, statute of limitations, and Freedom of Information Act requests.

Hot Topics in Criminal Tax Matters – An update on case law involving application of the required records exception to the privilege against self-incrimination in criminal matters, and other developments.

A Primer for Attorneys Serving on Nonprofit Boards – This presentation addresses issues attorneys face with serving on nonprofit boards, including fiduciary duties and responsibilities, potential conflicts of interest and ethical implications, scope of the attorney-client privilege and liability protection. This program will also provide a big picture summary of policies and procedures that directors and officers of California charities should know, including discussion of the IRS Governance Checklist and recommended policies and procedures in response to governance questions in the revised Form 990.

Sales Tax and Client Representation – An explanation of the sales tax audit and appeals process in California with a review of the mechanics of a markup audit and how to successfully defend a markup audit.

It Can Be Expensive to be a Responsible Party – A review and update on how the IRS and California taxing authorities hold “responsible parties” individually liable for unpaid corporate and LLC sales and employment taxes. How to advise your clients on avoiding these problems.

Defensive Strategies in Complex Civil Audits – What are some of the best techniques for dealing with a complicated civil audit?

Ethics and Conflicts of Interest – A review of common conflicts of interest faced by tax professionals and practical advice on dealing with potential and actual conflicts outside of the estate and gift tax arena.

Federal Procedural Roundtable – Panelists from the US Tax Court, IRS National Office, IRS Appeals and the Criminal Investigation Division discuss new developments in examination, appeals, enforcement, collection and litigation.

International Tax Compliance – How to assist clients with the increasingly complex and pervasive rules on international tax compliance including FACTA, FBAR penalties and opting out of the IRS voluntary disclose program. Also, the new streamlined filing compliance procedures related to the offshore bank accounts for non-resident U.S. taxpayers will be covered.

Upcoming TPL Committee Member Meetings

The next committee meeting will be on May 24, 2013 from 11:00 a.m. to 3:00 p.m. at the Law Offices of A. Lavar Taylor. The Committee will hear a review of the current state of the IRS Offer in Compromise program, including the new guidelines and how they are being implemented, from Steve Mather, Esq of Kajan, Mather and Barish, and Joseph A. Broyles, Esq.

We will also hear from Scott Telford, the FTB Program Manager for its Offer in Compromise program (Mr. Telford is also the Program Manager for the FTB’s Innocent Spouse and Probate programs). Mr. Telford has worked for nearly 18 years with the Franchise Tax Board, including as an Offer in Compromise Specialist in the late 90’s before rejoining the OIC program as a manager several years ago.

The TPL Committee Officers have agreed, very tentatively to meet at a date yet to be determined in August, 2013 in San Francisco, topic and location to be determined For more information please contact Jane Becker, Chair-Elect at:

California Tax Lawyer

If you would like to have a “Quick Point” included in the upcoming issue of the California Tax Lawyer, send me any brief 400 to 600 word technical updates, procedural updates, observations on practice or policy matters, and commentaries you may want to include at

Tax Network Newsletter

We continue to solicit articles for upcoming editions of our Tax Network Newsletter. Please co
ntact Joseph Wilson at if you would like more information or a helpful style manual for submitting articles for our next edition. The Newsletter continues to include wonderful information relevant to our members.

Bring Your Camera to the Annual Tax Bar Meeting and Quarterly Committee Meetings

The editors of the California Tax Lawyer would like to include pictures of our activities. Please send me via e-mail any JPEGS you may have from our meetings, and be sure to identify each person in the photo and the event at which the photo was taken.

Hot Topics

Thanks to all those who have helped make Committee meetings successful and fun. Please come armed with “Hot Topics” for our upcoming meeting. Our members continue to lead, teach and provide insight in our field, so there is much to share.

I hope to see you in Orange County in May!

David Klasing Esq. M.S.-Tax CPA Chair

Minutes of the February 1, 2013 TPL Committee Meeting

Submitted by Robert Horwitz, Esq.

The meeting of the Tax Procedure & Litigation Committee (TPL) of February 1, 2013, was held at the State Board of Equalization in Sacramento, California. The meeting was called to order by the Chair, David Klasing. The Chair announced that the minutes of the last meeting will be voted on by email when completed. The TPL submitted 13 topics to the Executive Committee for the 2013 Annual Meeting and 2 or 3 papers from TPL will be part of this year’s D.C. Delegation.

Hot Topics

James Counts met with the EDD Chief Deputy Director, Sharon Hilliard, who provided the following information:

  1. Lisa Wheeler has been named Acting Deputy Director, Tax Branch.
  2. A new Chief of Collections has been named who has worked in Collections for FTB with 25 years of experience in collections.
  3. The EDD is currently working on enhancing employer and tax representative online services by adding the ability to submit a penalty waiver request. Some would be worked automatically by the system and some would be sent to a person to work. EDD expects to have it available this spring.
  4. EDD has been working on a unity of entity problem since the new ACES system, but believes that it will be fixed by this summer. At that time EDD will begin working the backlog of an estimated 12,000 to 15,000 employers affected
  5. EDD UI Division is expected to have a major upgrade for a portion of its system completed this summer. Unfortunately, this upgrade is expected only to assist UI claimants and will not improve things for employers.
  6. The Legislature has not been willing to fund at one time an upgrade to the entire UI Division, so EDD has had to fix it piece meal.
  7. EDD is looking at what to do to all the deputy directors.
  8. It will be several months before a new Tax Branch Deputy Director is named. The Tax Branch now is reviewing their internal processes for doing things and looking at what they may be able to change to better take advantage of their new accounting system. No time frame on when they expect to complete the process.

The Chair stated that he has a client who sold a business and had $600,000 in escrow when the BOE put a lien on for the entire amount. There was a discussion of EDD successor liability. There was also a discussion of information between the IRS and state taxing agencies.

There was a discussion of tax shelter assessments by the IRS for old years where the FTB had a problem because the years involved were ones for which the FTB did not have information. Michael Cohen stated that when this occurs, the FTB sends a notice to the taxpayer asking for a copy of the returns for the years involved. If there is not one provided, then the FTB will assess tax based on the adjustments at the highest tax rate.

There followed a discussion of information sharing among California taxing agencies. Each agency uses different software and the systems don’t talk to each other. James Counts stated that the agencies are building an interface to exchange information once the Legislature approves.

The Speakers at the meeting were Anthony Epolite and Randy Ferris of the BOE. Mr. Epolite spoke on presentations before the Appeals Division. The topics he discussed were:

  1. Confidentiality Issues: For Franchise and Income Tax, filing an appeal to the BOE waives confidentiality as to all information filed with the BOE.
  2. Business and Sales Tax: A request for oral hearing waives confidentiality as to all information disclosed at the oral hearing and information disclosed in the case summary.
  3. Board Adjudications:
    1. Income Tax Deficiency Assessments – A taxpayer has to protest the NPA within 60 days. If the protest is denied, the taxpayer can file with the BOE.
    2. Income Tax Refund Claims: If a refund claim is denied, the taxpayer has 90 days within which to file with the BOE.

Mr. Epolite stated that briefs should include facts, the reasons why the taxpayer should prevail, the years and amounts in dispute, the taxpayer’s identification information and should request an oral hearing. The FTB has 90 days within which to file a reply and the taxpayer has 30 days to file a response. After the briefing is completed, Appeals acts as the gatekeeper in all files where an oral hearing is requested. Appeals can request additional briefing if it is needed to flesh out issues. Briefing can take a number of months to complete. Appeals looks at three things in an appeal – facts, legal argument, and supporting evidence.There was a discussion of the 3-part webinar on handling Tax Court cases. There was a discussion of discovery in Tax Court cases and motions to compel and innocent spouse issues, including the Ninth Circuit’s recent decision in Wilson, holding that the Tax Court reviews innocent spouse cases de novo.There was a discussion of the 3-part webinar on handling Tax Court cases. There was a discussion of discovery in Tax Court cases and motions to compel and innocent spouse issues, including the Ninth Circuit’s recent decision in Wilson, holding that the Tax Court reviews innocent spouse cases de novo.

Appeals has a similar role in Franchise Tax Appeals and Business Tax appeals. The Board members view appeals attorneys as their attorneys. For income and franchise tax appeals, the Appeals attorneys will prepare a summary of the case for the Board. As to factual development, the Board is the trier of fact. Generally, the Board does not use its subpoena power. Parties cannot compel witnesses to appear or provide evidence. In reviewing a case, the Board wants contemporaneous documentation, which it views as more helpful to members. In complex cases, hearings can last for several hours. Appeals tries to narrow issues as much as possible. The Board does not want surprises on the day of the hearing.

In sales tax cases, a taxpayer will file a petition for redetermination, which should include a request for an oral hearing and whether an appeals conference is requested. Appeals conferences are held at BOE field offices. A taxpayer can request the appeals conference be expedited.

A taxpayer should attend the appeals conference in person to tell his story and hear the BOE sales tax division position. After the appeals conference, the appeals attorney will prepare a Decision & Recommendation.

Appeals conferences are normally scheduled for 1 hour. The conferences are informal.

Evidence should be submitted at least 15 days before the hearing, if possible. At the appeals conference, the taxpayer’s representative should a) know what is being protested and why; b) bring documentation; c) should inform the appeals attorney what the adjustment should be (if you believe adjustments should be made); d) bring the taxpayer, who can answer any questions the appeals attorney may have.

At the conference, the appeals attorney will often ask the taxpayer to submit additional information within 15 days. BOE has 15 days to respond. After this, the appeals attorney will prepare his Decision & Recomm

Randy Ferris discussed ex parte communications with the BOE. It is permitted in tax appeals. Board members view taxpayers as both litigants and constituents who elect them. FTB attorneys do not communicate with the BOE members ex parte. The FTB cc’s the taxpayer on all communications with BOE.

In sales tax cases where the taxpayer is not represented, BOE staff will assist the taxpayer in how to present a case.

If a BOE member wants additional information, the appeals attorney will be contacted. The appeals attorney will contact the parties and ask for information.

Randy Ferris discussed settlement and appeals. These can be pursued simultaneously. If a settlement offer is made after a hearing, but before the Decision & Recommendation, the appeals attorney will not begin writing and will send documents to settlement. Mr. Ferris suggested that if the taxpayer is interested in settlement, he should get into settlement as soon as possible, since that is the quickest way to resolve the case. There is no communication between the appeals attorney and the BOE Settlement Division.

If there is a legal issue that has a continuing effect, the taxpayer can request a legal opinion from the Tax & Fees Division. The taxpayer can rely on this opinion until the BOE informs the taxpayer that the opinion can no longer be relied on. The BOE will not issue written guidance if the case is in the Appeals Division and there is no settlement pending. A taxpayer can get a written opinion within 3 to 4 months after a request in most cases.

A taxpayer needs to file a petition to get into settlement in a sales tax case. The Attorney General has to approve a settlement as reasonable and the settlement then goes to BOE for approval.

Bruce Langston of FTB Legal then stated that in FTB settlement, the taxpayer has to either pay in full the settlement amount or enter into a payment plan. Randy Ferris stated that the BOE allows a taxpayer to enter into a 12- month installment agreement where there is a settlement. Mr. Langston stated that the FTB’s position on collection while a BOE appeal is pending is that it cannot collect before the deficiency becomes final unless there is a jeopardy situation.

Mr. Langston also said that in 25% of cases, the FTB will concede if the taxpayer’s brief and supporting documents show that the FTB’s NPA is wrong.

A lunch break occurred from 12:45 to 1:40. After lunch, a discussion of hot topics resumed.

There was a discussion of problems with FTB collections. When dealing with the FTB, you have to ask for different types of transcripts: return record transcripts, lien transcripts, etc. There is not just one type of transcript. Mr. Langston stated that this should be pursued with the FTB taxpayer advocate.

There was a discussion of the 3-part webinar on handling Tax Court cases. There was a discussion of discovery in Tax Court cases and motions to compel and innocent spouse issues, including the Ninth Circuit’s recent decision in Wilson, holding that the Tax Court reviews innocent spouse cases de novo.

Bruce Langston then discussed the effect of Cutler v. FTB (2012) 208 Cal. App. 4th 1247, holding that the small business stock exclusion statute is unconstitutional. The FTB is now going back and assessing taxpayers who excluded gain from small business stock sales. Many are sales of start up companies.

With the passage of Proposition 30, a number of provisions in the Revenue & Taxation Code tie into the top marginal tax rates, which have gone up.

There was a discussion on single sales factor to base California corporation tax on amounts sold in California, which is explained on the FTB website.

Jim Counts discussed the Unemployment Insurance fund. In 1999, the Legislature increased benefits, but without increasing UI tax. The state is now in the hole and had to borrow $20 billion to pay benefits. So either the UI fund needs to increase tax or benefits will need to be cut.

There was a discussion of the audit of medical marijuana businesses by the IRS.

Basil Boutris raised the issue of FTB filing liens more than 20 years after the assessment, but claims it can do so because there was activity on the account. Bruce Langston stated that the position of the FTB is that the 20-year statute of limitations is based on 20 years from the last collection activity, including a payment, property location, a lien filed, etc. There followed a discussion of the California statute of limitations on collection.

The meeting adjourned at 3 pm.

Special Announcement: U.S. Officials Accuse IRS of Digital Espionage and Fourth Amendment Violations in Criminal Tax Investigations

Submitted by Joseph P. Wilson, Esq.

Concerns about the IRS’ practice of accessing taxpayers’ emails without a warrant have led several lawmakers to make inquiries to IRS officials about the legality of the practice. The IRS had earlier indicated that it can search and seize Americans’ emails, Facebook posts, tweets and other digital communications without a warrant.

During the week of April 8, 2013, Senator Mark Udall, D-N.M., criticized the IRS, saying the recently reported comments by the IRS run counter to the Fourth Amendment and the reasonable expectation Americans have that the government will not peruse such personal information absent a warrant. In the same time period, the Chairman of the House Ways and Means Subcommittee on Oversight, Charles W. Boustany, R-La., wrote the IRS asking for the Service to release all internal communications about its email search policy. Boustany said he views the recent reports of IRS accessing taxpayers’ electronic communications as “disturbing.”

The latest query came from Senate Finance Committee member Charles E. Grassley, RIowa, on April 16, 2013 when acting IRS Commissioner Steven T. Miller appeared before the panel to discuss tax fraud and identity theft. Grassley pressed the IRS to account for recent media reports stating that agency internal documents say agents have the ability to access taxpayer emails without warrants, despite a court opinion to the contrary. According to the media reports the IRS takes the position that it can access taxpayer emails without a warrant under the Electronic Communication Privacy Act.

Grassley told the IRS that it has a very high burden to treat taxpayers within legal bounds and without abusive intrusion of privacy. The agency’s written materials suggest agents have the ability to access taxpayer emails without warrants. Grassley requested that the IRS explain its aggressive stance in internal documents about accessing electronic communications and whether it in fact accessed electronic communications without search warrants and if so, when and why.

Grassley stated the Department of Justice applies a warrant-for-content requirement, which comes from the U.S. v. Warshak case from the Sixth Circuit. While the Act does allow federal agencies to obtain electronic communications from a remote computing service without a search warrant, provided they are older than 180 days, Grassley pointed out that the IRS’ position is contrary to the Sixth Circuit’s decision, where the court held that a search warrant is necessary to obtain any content of an email, regardless of age. See U.S. v. Warshak, 631 F.3d 266 (6th Cir. 2010).

In apparent response to questions from members of Congress on IRS practices regarding accessing taxpayers’ emails, the Service issued a statement on its website. The statement reads:

“Where the IRS already has an active criminal investigation and seeks to obtain the content of emails from an Internet Service Provider, we obtain a court ordered search warrant. It is not the IRS policy to seek the content of emails from ISPs in civil cases. Respecting taxpayer rights and taxpayer privacy are cornerstone principles for the IRS. Our job is to administer the nation’s tax laws, and we do so in a way that follows the law and treats taxpayers with respect. However, to resolve any remaining confusion surroundi
ng this issue, the IRS is reviewing its policy and guidance and will make appropriate updates.”

See om/IRS-Statement-on- Obtaining-eMails

It will be interesting to review any policy and guidance the IRS promulgates on this issue. I have seen the IRS request emails from the taxpayer and third parties in civil cases, such as the return preparer, but not directly from ISP’s. However, if the IRS believes this information is relevant to a civil audit or collection case and the IRS does not obtain this information directly from the taxpayer, I assume the IRS can issue a summons to obtain this information from the ISP, and that the U.S. Department of Justice could enforce it in U.S. District Court, as long as the “Powell Requirements,” as determined by the Supreme Court decision in United States vs. Powell, 379 US 48 (1964), have been satisfied. I have also submitted search warrants in criminal tax criminal investigations while at the U.S. Attorney’s Office and have never seen a situation where the IRS or DOJ attempted to obtain the content of emails from an ISP without a court ordered search warrant.

Joseph P. Wilson, Esq.

Law Offices of A. Lavar Taylor
6 Hutton Center, Suite 880
Santa Ana, CA 92707


Recently Proposed Amendment to the Federal Sentencing Guidelines Effect Criminal Tax Cases

Submitted by Steve Toscher, Esq. and Dennis Perez, Esq.

Since 1987, sentencing for tax crimes has been governed by the Federal Sentencing Guidelines (“Guidelines”). Those Guidelines generally provide that the punishment for tax crimes is determined by the amount of “tax loss” to the Government. For years, sentencing for tax crimes became mechanical, driven by a rigid application of the Guidelines. The rigidity of the Guidelines has been under pressure from their beginning with the first major change brought by the Supreme Court’s decision in Koon v. United States,1 when the Court provided District Court’s with greater discretion when it recognized that “it has been uniform and constant in federal judicial tradition for the sentencing judge to consider every convicted person as an individual and every case is a unique study in the human failings that sometimes mitigate, sometime magnify the crime and punishment to ensue.”

In 2005, the Supreme Court struck the final blow to the rigidity of the Sentencing Guidelines in United States v. Booker,2 when the Court held that based upon Sixth Amendment jurisprudence, the Guidelines were discretionary and the district courts were to consider the Guidelines, together with other sentencing factors contained in Title 18 U.S.C. Section 3553(a). The sentencing court is free to choose how much or how little reliance to place upon the Guidelines.3 The “over arching provision instruct[s] district courts to ‘impose a sentence sufficient but not greater than necessary’ to accomplish the goals of sentencing including ‘to reflect the seriousness of the offense,’ ‘to promote respect for the law,’ ‘to provide just punishment for the offense,’ ‘to afford adequate deterrence to criminal conduct’; and ‘to protect the public from further crimes of the defendant’.”4

Notwithstanding the now discretionary sentencing authority of the District Courts relating to tax and other crimes, the Sentencing Guidelines still play a central role in the sentencing of all federal offenses. The United States Sentencing Commission still maintains its role in administrating the Guideline system and each year reports to Congress and proposes amendments to the Guidelines as appropriate.

The Sentencing Commission recently proposed an amendment to the Guidelines, which could have a significant impact on the sentencing for federal tax crimes.5

Calculation of Tax Loss and Unclaimed Deductions

As noted above, the primary driver in determining the advisory Guideline sentence for a tax crime is the amount of the “tax loss.” For example, a tax loss of more than $200,000, has a base offense level of 18. Assuming no other adjustments, a level 18 provides for an advisory Guideline offense range of 27 to 33 months.

Assume the $200,000 tax loss was based upon omitted gross income, but also assume that in addition to the omission of gross income, the taxpayer omitted legitimate deductions. This happens more often than one would imagine, because deductions related to the fraudulently omitted income somehow seem to get left off the tax return–go figure.

These deductions are legitimate and with the allowance of the deductions, the tax loss is only $81,000. This would provide a base offense level of 16, which provides for an advisory sentencing range of 21 to 27 months. Thus, the unclaimed deductions can be very significant in terms of the sentence a tax defendant may receive.

Circuit courts have disagreed over whether the tax loss be reduced by the defendant’s legitimate but unclaimed deductions. The Tenth Circuit recently joined the Second Circuit in holding that sentencing court may give the defendant credit for a legitimate but unclaimed deduction. See United States v. Hoskins, 654 F.3d 1086, 1094 (10th Cir. 2011) (‘But where defendant offers convincing proof – where the court’s exercise is neither nebulous nor complex – nothing in the Guidelines prohibits a sentencing court from considering evidence of unclaimed deductions in analyzing a defendant’s estimate of the tax loss suffered by the government.’); United States v. Martinez-Rios, 143 F.3d 662, 671 (2d Cir. 1998 (‘the sentencing court need not base its tax loss calculation on gross unreported income if it can make a more accurate determination of the intended loss and that determination of the tax loss involves giving the defendant the benefit of legitimate but unclaimed deductions’); United States v. Gordon, 291 F.3d 181, 187 (2d Cir. 2002) (applying Martinez-Rios, the court held that the district erred when it refused to consider potential unclaimed deductions in its sentencing analysis). These cases generally reason that where a defendant offers convincing proof – the Guidelines do not prohibit a sentencing court from considering evidence of unclaimed deductions.

Other circuits – the Fourth, Fifth, Seventh, Eighth, Ninth, and Eleventh – have reached the opposite conclusion, finding that defendant may not present evidence of unclaimed deductions to reduce the tax loss. See United States v. Delfino, 510 F.3d 468, 473 (4th Cir. 2007) (‘The law simply does not require the district court to engage in [speculation as to what deductions would have been allowed], not does it entitle the Delfinos to the benefit of deductions they might have claimed now that they stand convicted of tax evasion.’); United States v. Phelps, 478 F.3d 680, 682 (5th Cir. 2007) (holding that the defendant could not reduce tax loss by taking a social security tax deduction that he did not claim on the false return); United States v. Chavin, 316 F.3d 666, 679 (7th
Cir. 2002) (holding that the definition of tax loss ‘excludes consideration of unclaimed deductions’); United States v. Psihos, 683 F.3d 777, 781-82 (7th Cir. 2012) (following Chavin in disallowing consideration of unclaimed deductions); United Sates v. Sherman, 372 F.App’x 668, 676-77 (9th Cir. 2010) United States v. Blevins, 542 F.3d 1200, 1203 (9th Cir. 2008) (declining to decide ‘whether an unclaimed tax benefit may ever

offset tax loss,’ but finding the district court properly declined to reduce tax loss based on taxpayers’ unclaimed deductions); United States v. Yip, 592 F3d 1035, 1041 (9th Cir. 2010) (‘We hold that § 2T1.1 does not entitle a defendant to reduce the tax loss charged to him by the amount of potentially legitimate, but unclaimed, deductions even if those deductions are related to the offense.’); United States v. Clarke, 562 F.3d 1158, 1164 (11th Cir. 2009) (holding that the defendant was not entitled to a tax loss calculation based on a filing status other than the one he actually used; ‘[t]he district court did not err in computing the tax loss based on the fraudulent return Clarke actually filed, and not on the tax return Clarke could have filed but did not.’).”

The Sentencing Commission recently issued proposals in an effort to resolve this circuit conflict. The Commission lays out three options. First, the tax loss would take into consideration any credit, deduction or exemption to which the defendant was entitled, whether or not originally claimed. Second, the tax loss should not account for any unclaimed items, unless originally claimed at the time the offense was committed. The third option is whether the unclaimed deductions will be considered if the defendant demonstrates by contemporaneous documentation that the defendant was entitled to the deduction or credit.

The Sentencing Commission has solicited comments on these proposals and options and may adopt the proposed amendment after comment. This would normally happen in May of the amendment cycle. Any amendment which is ultimately adopted and not vetoed by Congress will become effective November 1, 2013.

The courts have been struggling with the issue of allowing these unclaimed deductions and other unclaimed offsets. A very strong argument can be made that if we are going to punish tax offenders based upon the harm or tax loss, we should look to the actual tax harm or loss to the Government. If a restaurant owner decides to omit income, but also omit legitimate food costs which would otherwise be deductible, isn’t the actual harm to the government the lesser amount?

Allowing the deduction would be consistent with the current structure of the Guidelines, which sets forth that “tax loss” is 28% of the amount of unreported gross income for an individual “unless a more accurate determination of tax loss can be made.” Legal arguments can and have been made supporting both sides of the argument and this is something which the Sentencing Commission should resolve.

There is also a practical issue which has likely contributed to the disagreement among the circuit courts: a tax defendant’s last minute effort to offset the tax loss with unclaimed deductions – which otherwise have not been part of the investigation in the case, presents administrative problems and problems of proof. Sentencing courts do not want to become embroiled in mini tax loss trials, especially when the offsetting deductions have little or nothing to do with the investigation.

Nevertheless, because the Sentencing Guidelines rely upon tax loss as the primary driver for determining the advisory guideline range, it is important to have an accurate determination of that loss. If the taxpayer is able to demonstrate through credible proof that there are offsetting deductions or credits, those amounts should be allowed in determining the amount of harm. Such an interpretation is consistent with the doctrine of lenity6 in the criminal sentencing process and would seem to be the better view where an individual’s freedom is at stake. The courts are very capable with dealing with speculative and/or frivolous claims of offsetting deductions and credits.

Steven Toscher

Dennis Perez

Hochman, Salkin, Rettig, Toscher & Perez
9150 Wilshire Blvd, Suite 300
Beverly Hills, CA 90212
(310) 281-3200

Editorial Comment*

On April 10, 2013, the United States Sentencing Commission voted on its 2013 amendments. The proposed amendment to the sentencing guidelines (as promulgated) addresses the circuit conflict over whether a sentencing court, in calculating the tax loss in a tax case, may subtract the unclaimed deductions that the defendant legitimately could have claimed if he or she had filed an accurate tax return. The rule in the Ninth Circuit (and six others) was that a defendant may not present evidence of unclaimed deductions to reduce the tax loss. See United States v. Yip, 592 F.3d 1035, 1041 (9th Cir. 2010) (“We hold that § 2T1.1 does not entitle a defendant to reduce the tax loss charged to him by the amount of potentially legitimate, but unclaimed, deductions even if those deductions are related to the offense”).’

The proposed amendment resolves the conflict and provides a new application in the commentary in §2T1.1 to read as follows:

Unclaimed Credits, Deductions, and Exemptions.–In determining the tax loss, the court should account for the standard deduction and personal and dependent exemptions to which the defendant was entitled. In addition, the court should account for any unclaimed credit, deduction, or exemption that is needed to ensure a reasonable estimate of the tax loss, but only to the extent that (A) the credit, deduction, or exemption was related to the tax offense and could have been claimed at the time the tax offense was committed; (B) the credit, deduction, or exemption is reasonably and practicably ascertainable; and (C) the defendant presents information to support the credit, deduction, or exemption sufficiently in advance of sentencing to provide an adequate opportunity to evaluate whether it has sufficient indicia of reliability to support its probable accuracy (see §6A1.3 (Resolution of Disputed Factors) (Policy Statement)).

However, the court shall not account for payments to third parties made in a manner that encouraged or facilitated a separate violation of law (e.g., “under the table” payments to employees or expenses incurred to obstruct justice).

The burden is on the defendant to establish any such credit, deduction, or exemption by a preponderance of the evidence. See §6A1.3, comment.

The Sentencing Commission agrees that if the U.S. Department of Justice wants to put someone in Federal prison for a tax crime that the sentence imposed must be commensurate with the true harm that the defendant actually did cause. Thus, the U.S. Department of Justice can no longer obtain inflated sentences by barring a defendant from submitting the correct figures of tax loss during the sentencing phase of the case. A great result for someone charged with a tax crime in the Ninth Circuit.

The amendments can be found at Affairs/Newsroom/Press_Releases/20130410_ UNOFFICIAL_RFP_Amendments.pdf. The tax amendments can be found on page
61 of the proposed amendments to the sentencing guidelines (as promulgated).

The Big Boys get Better Treatment in our Tax System then Do Minnows

Submitted by Jack Townsend, Esq.

In Carl Levin’s October 5, 2012 letter to the leaders of the tax-writing committees, Senator Levin provides a list of what he calls “loopholes” related to U.S. offshore taxation that should be closed. Most of these loopholes he identifies are exploited by powerful U.S. corporations who have a major interest — translated into major lobbying — in keeping the loopholes as they are — exploitable and very lucrative in a zero-sum game with the U.S. fisc and U.S. taxpayers. The term loophole, in a broader sense, can refer to (i) provisions of law helping certain narrow interests, sometimes unintentionally or unknown to most legislators enacting them, or having real or perceived ambiguities, which can be exploited by powerful interests, or (ii) to deficiencies in enforcement of the legislative scheme where little or no ambiguity exists. In the latter sense, until recently, offshore accounts used for tax evasion might be considered loopholes — not legal ones, but practical ones because of enforcement deficiencies. So too, Son-of-Boss and other abusive tax shelters might have been considered loopholes until the IRS discovered their mass marketing and took steps to close down most of them, with collection of tax penalties and interest. The line between what is a loophole in the law and enforcement loopholes may sometimes be difficult to draw. This difficulty is what taxpayers and tax professionals such as those implementing the corporate shelters, discussed here, attempt to exploit by imagining different locations for the line than any rational person would believe it to be and hoping that the IRS’s enforcement deficiencies will give them a win in audit lottery or, if caught, will reward their imaginations will little or no penalties.

Senator Levin provides a list of loopholes that are variations of both varieties. Senator Levin’s list of loopholes:

  1. allow U.S. multinational corporations to shift profits offshore through abusive transfer pricing arrangements;
  2. allow U.S. multinationals to pretend to keep profits offshore, while actually returning offshore cash tax-free to the United States through serial loans;
  3. allow U.S. multinationals to pretend to keep profits offshore while using offshore subsidiaries to place the offshore cash in U.S. banks and investments;
  4. allow U.S. entities operated and managed out of the United States to incorporate offshore, claim foreign status, and dodge substantial U.S. taxes;
  5. allow U.S. financial firms to treat swap payments received from the United States as nontaxable foreign source income;
  6. allow U.S. multinationals to make an offshore subsidiary invisible for tax purposes and avoid taxation of passive offshore income under the so-called “check-the-box” and “CFC look-through” rules;
  7. allow U.S. multinationals to deduct the costs of moving jobs and operations offshore;
  8. allow mutual funds to dodge limits and taxes on commodity speculation by routing their commodity activities through offshore shell corporations;
  9. hamstring U.S. tax enforcement with inadequate tools to combat taxpayers hiding assets in secret tax haven bank accounts; and
  10. allow U.S. taxpayers to hide assets in U.S. bank accounts opened in the name of offshore entities.

Take for example transfer pricing. For those in the position to exploit transfer pricing beyond the hilt (mostly, at least in terms of magnitude, the large corporations), the tax shelter of choice is transfer pricing. Transfer pricing is inherently ambiguous and with manipulation can be made more ambiguous than it is. The rules of the game are easy to state — goods and services should be priced in a transaction between a U.S. taxpayer and its related offshore entity at the price that the U.S. taxpayer would sell to an unrelated taxpayer in an equivalent transaction.

The games that can be played with that standard are unbelievable and would make the conduct of U.S. persons eligible for or in the OVD programs look like rookies in terms of sophistication and the raid on the fisc. Yet, the latter get hammered and the former get, at best, a light tap on the wrist when they are among the unfortunate few who get caught because the IRS has inadequate enforcement budgets to detect most of the game playing in transfer pricing. Note that Senator Levin’s descriptions do not deal with “garden variety” transfer pricing abuse — simply improperly pricing related party transactions only a small fraction of which the IRS has any effective ability to review.

Jack Townsend

Townsend & Jones, L.L.P.
5615 Kirby Drive, Suite 830
Houston, TX 77005
(713) 521-9977

Preparing your Client for Pre-Sentencing

Submitted by Robert S. Horwitz, Esq.

The Internal Revenue Service recently touted its success in criminal tax cases by claiming a 93% conviction rate in criminal tax cases. It is difficult to determine the accuracy of this claim. According to the IRS’s published statistics on CI Enforcement, between 2008 and 2011, indictments or informations were filed in 10,525 cases and defendants were sentenced in 8,564 cases.7 This included both tax crimes and non-tax financial crimes (money laundering and currency violations). The number of indictments and informations handed down in Title 26 cases was 4,887, with defendants sentenced in 4,345 Title 26 cases. This translates into a conviction rate in Title 26 cases of 88.9%. The Department of Justice Tax Division, in its FY 2013 Congressional Budget, reported that in 2011 it authorized 2,320 prosecutions and the Tax Division’s “success rate” in cases it handled was 97%.8 In an April 9, 2013, press release, the Tax Division announced that in 2012 it had authorized 938 grand jury investigations and 1,751 prosecutions of individual defendants and that its success rate in civil and criminal tax cases was 95%.

Regardless of the exact percentage of convictions in criminal tax cases,9 if criminal tax charges are filed against your client, there is an extremely high likelihood that your client will be convicted and sentenced. In the majority of cases, the defendant will enter into a plea agreement rather than risk trial. Given the likelihood of conviction, it is therefore essential that an attorney representing a client in a criminal tax case begin early on to gather evidence that will allow a compelling case in mitigation to be presented to both the U.S. Attorney’s Office and the court for why the client should be sentenced at a belowguidelines sentence.

Since United States v. Booker, 543 U.S. 220 (2005), district courts at sentencing are required to consider all of the sentencing factors enumerated in 18 U.S.C. §3553, using the Guideline range as the starting point for determining the appropriate sentence.10 These sentencing factors include “(1) the nature and circumstances of the offense and the history and characteristics of the defendant; (2) the need for the sentence imposed … to provide the defendant with needed educational or vocational training, medical care, or other correctional treatment in the most effe
ctive manner.”11 The broad range of facts that a sentencing court can consider requires defense counsel to develop a factually compelling case in mitigation.

Laying the Foundation for Sentencing

The investigation necessary to develop a case for a below Guidelines range sentence should begin no later than when the Tax Division authorizes prosecution. You should initially conduct one or more detailed interviews with the client to gather information about family, schooling, mental health, substance abuse, employment and his or her relationship to the community. Such an interview is not only essential for preparing for sentencing, but it can also uncover information that can support a variety of defenses if the client goes to trial and can allow you to make an informed decision on how to advise your client on whether to testify at trial. In-depth interviews can also teach you how the client thinks so you are better able to advocate on behalf of your client at all stages of the proceeding.

Your client’s family and close friends and business associates should be interviewed.

First, like most people, clients are not always the most insightful or truthful about themselves and their background. These interviews should be conducted by an investigator.12 If the interview of the client or of family and friends reveals unusual behavior or evidence of substance abuse or a psychiatric condition, you should consider retaining professionals to conduct psychiatric evaluations, substance abuse assessments, diagnosis of learning disabilities and the like.13

To get medical records, school records, records of military service, and other documents you will need a written release signed by your client. These records are often helpful in placing the client in context and humanizing the client to the court.

The client and witness interviews are essential to developing a theory of the case for sentencing purposes. These theories can run the gambit of the factors laid out in 3553(a), including rehabilitation, treatment, punishment, integrating the client into the community and restitution. The theory you choose should take into consideration what you know about the sentencing judge who will decide your client’s fate. The theory will also allow you to present a plan for the appropriate punishment, which you can advocate both with the probation officer who is assigned to your client’s case and to the court.

Because this is your client’s case, you should get him or her involved in preparing for sentencing, including identifying witnesses who can provide letters of reference for the court, gathering together documents and preparing the draft worksheet for the presentence report.

Pre-Trial Services Interview

In deciding the sentence to impose on a defendant convicted of a crime, the district court relies upon the pre-sentence report (PSR) prepared by the Probation Department. The probation officer, in the PSR, makes a number of crucial determinations, including the appropriate Guideline range, whether any enhancements apply, and the facts concerning your client’s background and life history. It is your job to ensure that the probation officer comes to see the facts in a light favorable to your client in order to get a favorable PSR. Remember that it is easier to convince the judge to be lenient at sentencing if the PSR does not contain unfavorable misinformation and does not urge the applicability of enhancements.

The probation department requires detailed life history and financial information from a defendant. Most U.S. Probation Offices use a worksheet in preparing the pre-sentence report. You should work with your client to complete an accurate worksheet to give to the probation officer, together with the back-up documentation that is called for.14 These will include bank statement, pay stubs, tax returns and other documents. The documents should be tabbed with a cover index to provide to the probation officer. You should try to make the probation officer’s work as easy as possible so that he or she will be predisposed to give your client the benefit of the doubt.

The client will need to be prepared for the presentence interview. You should explain the pre-sentencing process to the client, what will occur, the importance of the interview and how to act during the interview. Since most probation officers will go through the questions in the worksheet, you should conduct mock interviews of the client so that he or she is comfortable with the process and knows how to respond to questions. This does not mean that your client should be preprogrammed to give specific answers. The client needs to know that it is necessary to respond to the question, not to be evasive, not to lie and not to make self-serving statements that may lead the probation officer to conclude that your client is not really accepting responsibility for the crime. Your client should be prepared to explain (if asked) his actions in a manner that shows he is accepting responsibility.

You should draft a letter to give to the Probation Officer at the time of the interview that outlines your view of the case and what you believe the appropriate sentence. You should cite any supporting cases for the position you advocate. Remember that the prosecutor will usually lobby the probation officer for a Guidelines range sentence and may also try to convince the probation officer that enhancements apply.15

If the client is not a native speaker of English, you should contact the probation officer so that an interpreter can be available at the time of the interview. You should never let your client go alone to the pre-sentence interview. Either you or an attorney who has worked with you and the client on the case should accompany the client. You will need to ensure that your client gives complete, accurate and truthful responses to the probation officer’s questions and is respectful of the probation officer. During the interview you will be able to advocate your client’s position with the probation officer. Make sure that you find out the cutoff date by which the probation officer will need to receive additional information to include it in the presentence report.

Supporting Letters

Supporting letters from family, friends, business associates, co-workers and members of the community who know your client can provide insights into your client to assist the court in determining a sentence. You should have your client identify people who can vouch for him and provide you with their contact information. You should contact these individuals; explain to them the sentencing process and the type of letter that would be most helpful to your client. The letters should paint a picture that a substantial period of incarceration will serve no useful purpose. If the circumstances warrant it, such letters can also point out that any lengthy period of incarceration could jeopardize your client’s ability to support his or her family. If your client employs people in his or her business, letters from business associates and employees that point out how essential your client is to the business’s continued operation and the workers’ jobs should be obtained, if that is in fact the case.

The letters should be sent to you before they are finalized and sent to the court,
so that you can suggest any appropriate changes. The final signed letters should be sent to you to forward to the Court with your sentencing materials and, if the letters are received before the completion of the pre-sentence report, to the probation officer.

You should also consider whether the client should prepare a letter to the court that explains his actions and accepts responsibility for what was done. If your client is willing to write such a letter, it should not lead the court to conclude that the client is sorry because he or she was caught, but because they realize the gravity of the offense and its effects upon society, their family and friends and themselves.


Often, sentencing is the most time-consuming and exhausting part of a criminal case. Since most cases end in plea agreements, it is typically the phase where your client’s fate is sealed. Just because your client has entered into a plea agreement does not mean that your job as an advocate is over. Adequate and thoughtful pre-sentencing preparation, including ensuring that the probation officer is provided with a positive view of your client, will assist you in obtaining for your client a favorable sentence.

Robert S. Horwitz, Esq.

Law Offices of A. Lavar Taylor
6 Hutton Center Dr., Ste. 880
Santa Ana, CA 92707

Time’s A Ticking: IRS Voluntary Classification Settlement Program (VSCP)

Submitted by Lisa Barnett, Esq.

The IRS Voluntary Classification Settlement Program (“VSCP”) is not a new program available to employers. The VSCP was first introduced by the IRS on September 12, 2011. The IRS developed this program to permit taxpayers to voluntarily reclassify workers as employees for federal employment tax purposes. This program allows eligible taxpayers to voluntarily come forward and obtain the relief offered in VSCP rather than wait for an IRS employment tax audit to obtain similar relief via the Classification Settlement Program (CSP) available in the early stages of an audit. However, if an employer waits until they are audited, they should note that relief offered under CSP is not available to taxpayers if they did not have a reasonable basis for not treating the worker as an employee16 or if the liability was due to an “intentional disregard of the requirement to deduct and withhold” employment taxes.17 It appears from the eligibility requirements below, that such requirements are not prerequisites for a taxpayer to participate in VSCP.

Under the VSCP program, there are eligibility requirements that must be met in order to take advantage of the relief that VSCP offers: 18

  1. The employer must have currently and have consistently treated their workers (or class or group of workers) as independent contractors or nonemployees.
  2. The employer must have filed all required Forms 1099 for such workers for the previous three years.
  3. Such employer cannot be currently under an employment tax audit by the IRS (any other audit by the IRS will not make an employer ineligible for VSCP).
  4. Such employer also cannot be currently under audit by the Department of Labor or by any state government agency.
  5. If the employer has been previously audited by any of the above entities, the employer must have complied with the results of the audit.
  6. The employer must also not be currently contesting in court the classification of the class (es) of workers in court from a previous audit with any entity.

Recently, there has been renewed interest in the VSCP due to the quickly approaching June 30, 2013 deadline. June 30th could be the final deadline for many employers to take advantage of this program.19

The above mentioned eligibility requirements, benefits and consequences remain intact even after the June 30th deadline. The June 30th deadline is most important to employers that do not normally qualify for VCSP. IRS Announcement 2012-46 provided a temporary expansion of eligibility into the VSCP. This Announcement specifically allows employers who did not comply with the number two eligibility requirement above to now be eligible for VSCP despite their failure to file all the required Forms 1099

What are the benefits for voluntarily entering into VSCP? The largest benefit is that the program can save employers a lot of money in interest and penalties that could be incurred if a worker classification audit did occur. In the VSCP, the employer will need to pay only 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year as determined under the reduced rates of IRC §3509. The employer will also not be liable for any interest and penalties on the liability. Entering into this program ensures that the employer will not be subject to an employment tax audit with respect to the classification for the same workers that were voluntarily reclassified in the VSCP for prior years.

In exchange for this monetary relief and peace of mind, employers must agree to treat the class of workers as employees for future tax periods. Lastly, the employer must enter into a closing agreement with the IRS and make a full and complete payment of any amount due.

Employers who fit into this temporary expansion will pay a higher percent of 25% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year still determined under the reduced rates of IRC 3509. However, the taxpayer will still not be liable for any interest and penalties on the liability. Additionally, the taxpayer will not be subject to an employment tax audit with respect to the worker classification of the workers being reclassified for prior years.

Eligible VSCP employers falling into the Announcement 2012-46 targeted group must furnish to their workers and electronically file all required Forms 1099 for the workers being reclassified for the previous three years prior to executing the closing agreement with the IRS. Employers who fail to file Forms 1099 timely generally are subject to penalties. The temporary VSCP expansion does not remove the assessment of penalties for failure to file required Forms 1099, but does provide a reduced, graduated penalty for unfiled Forms 1099 for the previous three years for the workers being reclassified as summarized below.

Form 1099 Penalty Calculation Comparison:
VSCP Form 1099 Penalty Calculation$50-$100 per each non-filed Forms 1099
General Form 1099 Penalty Calculation$30-$100 per each non-filed Forms 1099

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In the FAQS, the IRS specifically states that it will not share information about VCSP applicants with the Department of Labor or state agencies.20 Additionally, rejection of a VCSP application will not automatically trigger initiation of a federal audit. 21

Taxpayers should note that the IRS has continued its criminal prosecution related to employment taxes. Recently on January 14, 2013, Tom Seng, owner of S&T Industrial Service, Inc. pled guilty to 20 counts of making and subscribing a false tax return regarding how many workers he employed. The tax loss amounted to approximately $2M.22 The IRS Criminal Investigation (CI) Division also publishes statistical data regarding its investigations including for the specific category of employment taxes.23 In a fiscal year which runs from October to September, the IRS CI Division initiates on average 156 investigations related to employment tax evasion. From that, approximately 104 are recommended for prosecution. Approximately 81% are incarcerated which includes confinement in federal prison, home detention, halfway house, or a combination of the three. Therefore, before the deadline runs out for the taxpayers falling into the expanded eligibility requirements, taxpayers should consider whether to take advantage of this program before they lose this limited opportunity. While there is a renewed awareness of the VCSP due to the temporary expansion, other eligible employers should consider whether this program might be right for them as well.

Lisa Barnett

Law Offices of A. Lavar Taylor
6 Hutton Center, Suite 880
Santa Ana, CA 92707

Recent Cases of Interest

Robert S. Horwitz, Esq.

A common refrain repeated in many bogus tax evasion transactions is that the taxpayer’s business purpose was to obtain low cost, longterm financing. This was sung by the taxpayers in defending their abusive transactions in Felcyn v. United States, 691 F.Supp. 205 (CD CA 1988) (involving a series of shelters put together by Harry Margolis in the late 1970s) and by shelter promoter Gerald Shulman in his criminal trial to explain his transactions. Shulman v. United States, 817 F.2d 1355 (9th Cir. 1987), subsequent proceedings, 889 F.2d 1097 (9th Cir. 1989) (affirming conviction), 12 F.3d 1110 (9th Cir. 1993) (affirming denial of habeas petition). To give a veneer of legitimacy to this refrain, shelter promoters and their clients often find major banks to act as the willing enablers of their evasion schemes.

District Judge Brian Jackson hit the nail on the head when he noted that to determine whether a tax scam engaged in by Dow Chemical (with the assistance of Goldman Sachs, King & Spalding and a host of major foreign banks) generated the tax benefits claimed he needed to “distinguish the mere avoidance of taxes from legally circumscribed tax evasion.” Chemtech Royalty Associates, L.P. v. United States, 2013 U.S. Dist. LEXIS 26329 (MD LA 2/26/2013). There, Dow Chemical engaged in two complex SLIPS (“Special Limited Investment Partnership”) transactions for the supposed business purpose of obtaining “off balance sheet financing.” Or at least that is what Dow claimed, since one of the law firms who advised the promoter, Goldman Sachs, stated that business purpose was essential to having the transaction recognized for tax purposes.

Goldman Sachs sold a number of SLIPS in the early 1990s to major American corporations. According to Goldman Sachs’ promotional materials, its ultimate goal in these transactions was to find “equity that was tax deductible.” Or at least artificially increase the basis in assets to create phony deductions. Goldman sold one such transaction to Dow, which used it to generate hundreds of millions of dollars of fake royalty deductions between 1993 and 1997. King & Spalding “implemented” the Goldman Sachs’ transaction. In 1998, it designed and implemented a second transaction using the same limited partnership (Chemtech Royalty Associates, L.P.) to generate millions of dollars in bogus depreciation deductions between 1998 and 2003 through a step up in the basis of a chemical plant. The Court held that both sets of transactions had to be disregarded because 1) they lacked economic substance; 2) the partnerships were shams without any legitimate business purpose; and 3) even if the partnerships were respected as separate entities, the banks who were involved in the transactions were not true equity partners.

In the first SLIPS transaction (Chemtech I), as Step 1, Dow identified 73 patents in which it had a tax basis of $54,000. These patents were to be transferred, through a series of subsidiaries, to the Chemtech limited partnership, which claimed that the patents were worth $867 million (based on an appraisal by Arthur D. Little, Inc.). Although the limited partnership had the right to license the patents to third parties, Dow did not transfer to it all of the technology needed to make the patents useful to any other entity. Thus, the right was meaningless.

Step 2 involved selecting the Dow entities to act as partners. These were a) Dow Europe S.A., which put up $10 million cash, as the 1% general partner, and b) Chemtech Portfolio I (CPI) as an 88% limited partner. CPI was a subsidiary of Dow Technology Partnership Corporation (DTPC) that was headquartered in Bermuda. Dow transferred the patents to CPI to contribute to the limited partnership. Besides the patents, DTPC, through CPI, contributed to Chemtech I $100 million cash and all of the stock CPI purportedly worth $215 million.

Step 3 required Goldman to put together a consortium of foreign banks to acquire limited partnership interests. Under the deal, the banks were to get a guaranteed annual return on the money they put up ($200 million) that was above the prevailing interest rate on corporate bonds. The banks were also guaranteed to get back their investment in the partnership. The banks had no qualms in engaging in the transaction.

With the partnership in place and the patents in its name, Dow then made royalty payments to the partnership, which it deducted on its tax returns. In doing so, it appeared oblivious to the fact that the money (except for fees) moved in a circle. The money flow in 1994 was typical:

  1. Dow paid Chemtech I $144 million for the use of patents.
  2. Chemtech I paid $760,000 as a management fee to Dow Europe
  3. Chemtech I paid the foreign banks their annual guaranteed return
  4. Chemtech I made a modest tax payment to Switzerland
  5. Chemtech I paid the remainder to CPI
  6. CPI “loaned” back to Dow $137 million

The only cost to Chemtech I was the management fee, so it had income of $143 million. Under the limited partnership agreement, $115 million was allocated to the foreign banks and $28 million was allocated to Dow (through CPI and DTPC). Dow’s use of the patents did not change during these years. Transferring the patents to Chemtech I did not increase their value to Dow. All that happened was that, for a fee paid to the banks, Dow claimed a net royalty payment deduction of $116 million.

This continued through 1997, when the IRS issued new regulations t
hat could have resulted in the 30% withholding tax being applied to the payments to the foreign banks. With their profit threatened, the banks withdrew from the partnership in early 1998 and received a distribution of $210 million cash.

Dow now had the Chemtech entity and had to devise a use for it. King & Spalding came up with a new transaction involving the transfer of a chemical plant in Louisiana to Chemtech, which formed the basis of the transaction referred to by the court as “Chemtech II.”

Dow was faced with a major problem in forming Chemtech II: it wanted to get back the patents that were transferred to Chemtech as part of the first transaction and it wanted the CPI stock to go back to DPTC. The problem was that CPI consisted of $750 million in cash, securities and Dow demand notes. Dow was advised that the CPI assets would be deemed “marketable securities” and its distribution would result in substantial taxable gain under IRC §731. Dow’s answer was to replace the securities with a “deeply subordinated” 33-year note that would not be “marketable securities.” Like the formation of Chemtech I, Chemtech II involved several steps:

Step 1 was the 1998 transfer by Dow of a chemical plant in Louisiana to Dow Chemical Delaware Corp. (“DCDC”) plus all of the stock in CPI II, another Dow subsidiary. DCDC contributed the plant and the stock to Chemtech and Dow entered into an agreement to lease back the plant.

Step 2 was to get a bank-affiliate as a partner. In Chemtech II, this was RBDC, a U.S. affiliate of Rabobank, which was admitted as a partner to Chemtech II after it purchased $200 million in credit default swaps from Dow. Ifco, a Dow subsidiary that had been a partner in Chemtech I remained a partner. At this point, Chemtech II had 3 partners, Ifco, as general partner with 6.37%, DCDC as a limited partner with 73.18% and RBDC as a limited partner with 20.45%.

Step 3 involved increasing the basis in the chemical plant. To do this, Chemtech II made a §754 election, stripping $381 million from the basis of the CPI that was distributed out to DPTC and applying it to the chemical plant.

In Chemtech II, RBDC was guaranteed an annual rate of return and the repayment of its investment. All depreciation was allocated to the Dow subsidiaries, Ifco and DCDC, both of which were part of Dow’s consolidated return. Dow continued to use and manage the chemical plant, which it leased from Chemtech II under a triple net lease.

Consistent with the Chemtech I transaction, the cash flows in Chemtech II were circular. The cash flow in 1999 is typical:

  1. Dow paid “rent” to Chemtech II of $69 million.
  2. Chemtech paid Ifco a management fee of $400,000.
  3. Chemtech II paid RBDC $12.75 million as its annual return.
  4. Chemtech II “loaned” $57 million back to Dow.

On its 1999 tax return, Chemtech II reported income of $69 million, a management fee of $400,000, and depreciation of $115 million.

The depreciation and $56 million of income were allocated to Ifco and DCDC, which flowed through on Dow’s return as a net loss of $59 million, plus rent of $69 million, for a total reduction in income of $128 million. Because Chemtech II used double declining balance depreciation, the net loss for Dow each year decreased, but over the period 1999 through 2003, Dow’s deductions from the Chemtech II transaction were almost $300 million.

The Court noted that a crucial inquiry was whether the banks’ interest in the two partnerships was debt or equity. If debt, than the banks were not partners. Although Dow claimed that the banks’ interest was equity, the internal records of the banks showed that all of them viewed their interests as participation loans. Additionally, Dow gave the banks numerous protections similar to those given a lender. Dow effectively guaranteed revenues to Chemtech and limited spending to the management fee; profits were thus guaranteed to ensure payment to the banks at a 6.94% rate of return each year. Although the banks were entitled to participate in “excess profits,” because Dow could and did withdraw assets from Chemtech, this never happened.

Due to the triple net leases, in both transactions Dow was responsible for all costs associated with both the chemical plant and the patents. Among other things, Dow effectively agreed to indemnify Chemtech from losses if the patents were invalidated or if the plant became obsolete or unproductive. Dow also agreed to indemnify the banks for any adverse tax consequences of the transactions. Finally, the banks did not have any management or control rights over Chemtech. All of these factors led the court to conclude that the banks’ interest was debt and not equity.

The court then turned to whether the transaction had economic substance. Dow’s asserted business purpose was to help its credit rating by off balance sheet financing since the moneys invested by the banks would not be treated as debt on Dow’s balance sheet and, thus, would keep its debt to capital ratio low. This, in turn, would lead to Dow’s getting a better rating from credit rating bureaus and result in its paying a lower interest rate on funds it borrowed.

The court rejected Dow’s claimed business purpose. First, Dow failed to show any project it identified for investment prior to the transactions and no Dow official could point to any specific use by Dow of the funds that the banks put into Chemtech, or of the funds that went to Dow from Chemtech. There was no apparent reason for the transactions besides tax benefits. As to the claim that the transaction helped Dow’s credit rating, the court noted that Standard & Poor’s does not base its credit ratings on a company’s ratios at one instance of time, but instead looks at the company’s performance over an entire business cycle. There was also no evidence that Dow investigated alternatives to the Chemtech transactions for “off balance sheet financing.” The court concluded that “Dow’s professed business purpose is a false wall in the maze of the Chemtech transactions” and that the maze ended in tax benefits to Dow.

The court then addressed the economic substance doctrine. The lead case is Frank Lyons, 435 U.S. 561, 583-84 (1978), where the Supreme Court held:

In short, we hold that where, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached, the Government should honor the allocation of the rights and duties effectuated by the parties.

According to the district court, “the conjunctive phrasing of the above factors is important: the absence of any one of them renders the transaction void for tax purposes.” Under the Fifth Circuit’s post-Lyons case law, to show that a transaction had economic substance, a taxpayer must show both a) that it had a reasonable possibility of profit and b) that it was motivated to enter into the transaction for a legitimate non-tax business purpose.

The court addressed the objective prong, which focuses on “the particular transaction that gives rise to the tax benefits, not collateral transactions that do not produce tax benefits.” If there is no objective economic substance, the transaction is invalid regardless of the taxpayer’s non-tax motive. Based on its analysis of the facts, the court found that 1) the transfer of assets to Chemtech I and Chemtech II did not result in any economic advantage to Dow; 2) the transactions did not change Dow’s economic position; and 3) Dow and its subsidiaries were the only parties to the exchange of the term notes for the long-term subordinated debt, which was done specifically to avoid triggering taxable gain on the distribution of Chemtech I assets under §731. Neither Chemtech transaction had any effect on Dow’s financial position, other than tax benefits, so neither transaction had objective economic substance.

ng determined that Dow flunked the objective prong of the test, the court turned to the subjective prong. Notwithstanding Dow’s claim that it entered into the transactions to sustain its credit rating through the use of off balance sheet financing, it did nothing to investigate cheaper and simpler methods to achieve this goal. Dow’s only real purpose in entering into the transaction was tax avoidance. Thus it flunked the subjective economic substance test.

The court then addressed the sham partnership doctrine, which had its inception in Culbertson v. Commissioner, 337 US 733 (1949). Under this doctrine, unless the partners entered into the partnership in good faith and for the purpose of carrying on a business jointly and sharing its profits and losses, it is not a partnership for tax purposes. According to the court, the question was not whether the transaction had economic substance, but whether the partnership had substance. The court held that the partnerships (Chemtech I and Chemtech II) were clearly sham. Both partnerships were set up so that Dow could continue to use its patents and its chemical plant as if no transfer occurred. There were no additional revenues generated by the transaction and the funds moved in a circle between and among related entities. The banks were guaranteed a specific rate of return and guaranteed against any loss, and had no meaningful risk of loss or profit other than the guaranteed rate of return. They were not partners in either partnership and, thus, the partnerships were sham.

The court did not feel it necessary to address any other issue raised by the Government. This set the stage for its handling of penalties.

The IRS proposed both the 20% substantial understatement/negligence penalty and the 40% gross valuation misstatement penalty. The court held that Dow was liable for the 20% penalty, since it was a highly sophisticated company with numerous lawyers and tax professionals and knew of the need for a legitimate business purpose for either transaction to be recognized for tax purposes. It’s claimed business purpose “was nothing but window dressing” to disguise its tax motives. Thus the 20% penalty applied.

The court refused to impose the 40% penalty. The Fifth Circuit, to which the decision is appealable, is one of only two circuits that hold that the 40% gross valuation misstatement penalty does not apply if a transaction is disregarded on other grounds, such as economic substance. The other circuit is the Ninth Circuit. Because the court held that the transaction was to be disregarded under the economic substance and sham partnership doctrines, and expressly declined to reach the valuation issue, it held that the 40% penalty did not apply.

On March 25, 2012, the Supreme Court granted certiorari in United States v. Woods to resolve the conflict on this issue. As of this writing, a final judgment has not been entered in Chemtech Royalty, so the time to file an appeal has not yet begun to run. Given the grant of certiorari in Woods, it can be anticipated that the Government will file an appeal from the district court’s refusal to impose the 40% penalty.

Then there is the Structured Trust Advantaged Repackaged Securities (STARS) transaction entered into by Bank of New York in Bank of New York Mellon Corporation v. Commissioner, 140 T.C. No. 2 (2/11/2013). The STARS transaction was another complex web of entities and transactions, this time developed and promoted by Barclay’s Bank, PLC (as in LIBOR scandal) and KPMG. The target market was major US banks. Bank of New York (BNY) entered into the transaction in 2001. During 2001 and 2002, BNY claimed over $199 in foreign tax credits as a result of the transaction.

The STARS transaction involved numerous entities and several steps. In Step 1, BNY contributed $6.46 billion in assets to a preexisting subsidiary, BNY REIT Holdings, LLC (“Holdings), which assumed $2.55 billion in BNY liabilities. The assets were participating interests in residential and commercial mortgage loans and consumer loans and other asset-backed securities,

In Step 2, BNY formed BNY Investment Holdings (DE), LLC (InvestCo), which elected to be treated as a corporation for tax purposes and was part of the BNY affiliated group. Holdings contributed $10.4 billion in assets to InvestCo, consisting of the assets BNY contributed to it together with Holdings stock with a stated value of $3.95 billion and InvestCo assumed liability on the BNY liabilities. The assets contributed to InvestCo were called the “STARS assets.” InvestCo issued 100% of its membership interests to Holdings.

In Step 3, BNY formed BNY Delaware Funding, LLC (DelCo), which elected to be treated as a partnership for tax purposes. InvestCo contributed $9.243 billion of STARS assets to DelCo, which assumed the BNY liabilities. DelCo issued all of its class 1 interests (worth $65 million) and its class 2 interests (worth $6.628 billion) to InvestCo. All voting and management rights were in the holder of the class 1 interests. The holders of the class 2 interests had the right to 99% of DelCo’s distributions, which were to be made at the complete discretion of the managers.

Step 4 involved BNY’s establishment of a common law trust, the BNY STARS Trust, which had 4 classes of units: A, B, C, and D. Class A holders were entitled to 1% of trust distributable income. Class D holders were entitled to a distribution based on a formula tied to LIBOR rates. Class B holders were entitled to 99% of the remaining trust distributable income, unless Class C had not been issued, in which case Class B holders were entitled to 100% of remaining distributable income. The remaining distributable income was to go to Class C holders, unless there was a default. InvestCo transferred its remaining STARS assets (worth $1.2 billion) and its DelCo class 2 interests to the STARS Trust in exchange for the Class A and B units, which were valued at $6.3 billion and $1.2 billion. The initial trustee was BNY and the initial trust manager was a BNY subsidiary.

We now come to Step 5: BNY formed NewCo Funding, LLC, with InvestCo as its sole member. InvestCo contributed 49% of the Class A trust units to NewCo in exchange for all of its membership units, with a stated value of $3.089 billion. InvestCo then distributed 1% of the membership units to Holdings. NewCo elected to be treated as a partnership for tax purposes.

Step 6 was the creation of a $1.5 billion loan from Barclays to BNY. This loan involved a number of steps, beginning with Barclays entering into a subscription agreement under which it purchased the Class C and Class D STARS Trust units for $1.469 billion and $25 million, respectively. Under the agreement, Barclays was to pay to the trust additional subscription amounts equal to the amounts of any distributions on the Class C units.

To ensure payment, BNY established a blocked account into which Class C distributions were to be paid. Then Barclays and InvestCo entered into a forward sales agreement and a zero coupon swap and DelCo and the STARS Trust contributed $2.598 billion in STARS assets to securities accounts in which Barclays was granted a security interest. Under the forward sales agreement, InvestCo agreed to buy back the Class C units from Barclays in 2006 for the amount Barclays paid plus interest at 4.338% per annum, less any UK tax paid on trust income. InvestCo also agreed to buy back the Class D units for $25 million plus any unpaid distributions of trust income allocated to the Class D units.

BNY next entered into an agreement guaranteeing payments under the forward sales agreements and the zero coupon swaps and Barclays agreed to pay BNY a fixed rate of 10 basis points on a notional amount of $1.475 billion. Finally, BNY guaranteed that the accounts in which Barclays was granted a security interest held at least $2.25 billion in high-grade securities as collateral for as long as Barclays held the Class C trust units.

As a result of this transaction, Barclays’ initial subscrip
tion was converted into a $1.5 billion loan from it to BNY with interest at LIBOR plus 20 basis points. Interest was paid through the zero coupon swap (excluding any spread) and the principal was to be repaid through the forward sales agreements.

With the money it received from Barclays’ subscription STARS Trust redeemed InvestCo’s Class B units. InvestCo deposited the $1.494 billion it got from the redemption in the Cayman Islands branch of BNY. The Cayman Islands bank booked the deposit as a liability to Barclays.

BNY and Barclays next named a UK subsidiary of BNY as the trustee of the STARS Trust, which allowed the trust to be treated as a UK resident for tax purposes. Barclays and BNY also entered into agreements to allocate risks and each had the right to terminate the transaction on notice.

Delco held the STARS assets. It distributed monthly 1% of STARS income to InvestCo, as class 1 shareholder, and 99% to the STARS Trust as class 2 shareholder. The Trust had income from the DelCo distributions and the Trust assets. It set aside 22% of its income as a reserve for UK taxes, which it periodically paid to U.K. taxing authorities. It distributed the remaining income to trust unit holders. Most of the income went to the Barclays blocked account, which was used to pay Barclays’ obligation to the Trust for additional subscription amounts. Class D unit distributions, totaling $7 million over the term of the Trust, were paid to Barclays. Under the term of the STARS, Barclays made net payments to BNY under the zero coupon swap and credit default swap.

STARS terminated in 2006 when InvestCo and Barclays fulfilled all of their obligations under the credit default swap and the zero coupon swap.

BNY reported the STARS income as foreign source income on its U.S. consolidated corporate income tax return. In 2001 and 2002 it claimed foreign tax credits of $98.6 million and $103.2 million, respectively. It deducted as interest the Class D distributions to Barclays and treated payments under the zero coupon swap in a manner that resulted in additional interest deductions. It also deducted transaction fees and costs. The IRS issued a notice of deficiency disallowing the foreign tax credits and the deductions for interest and transaction costs and reclassifying the STARS transaction income as U.S. source income.

The Tax Court agreed with the IRS under the economic substance doctrine. The Tax Court recognized that the Courts of Appeal have various ways of applying the substance over form doctrine. Since the case was appealable to the Second Circuit, it followed the Second Circuit’s case law, which applies “a flexible analysis for assessing economic substance.” Under this approach, objective economic substance and subjective business purpose are two components of the analysis. A finding of a lack of either can, but does not necessarily, invalidate a transaction for tax purposes.

Initially, the Court had to determine what it was analyzing. It rejected BNY’s assertion that the inquiry should focus on all components as an integrated arrangement in order to determine its validity for tax purposes. It agreed with the IRS that its focus should be on the STARS structure and not the loan to determine if there was economic substance. To do this, it had to focus on the transaction that generated the claimed tax benefits, regardless of whether this transaction was part of a larger set of transactions. The Court identified the focus of inquiry as the “circulating [of] income through the STARS structure” that produced the foreign tax credits, and not the loan component, which was unnecessary to produce the foreign tax credits.

Looking to the objective component of the economic substance doctrine, the Court determined that BNY did not have a reasonable expectation of non-tax economic profit from the use of the STARS structure. In fact, the use of the structure decreased the profitability of the STARS assets due to the substantial transaction costs involved: professional fees and U.K. taxes. The STARS structure, which was set up to circulate money between itself and Barclays, did not provide a reasonable opportunity of economic profit. In effect, most of the trust income went in a circle from DelCo into the blocked account and then back to DelCo, where it was available for use by BNY. The Court viewed this as strong evidence that the transaction was without economic substance, but was created merely to generate tax benefits.

The Court declined BNY’s invitation to consider the income generated by the STARS assets in determining whether there was the chance to make an economic profit, since BNY’s ultimate control and management over STARS’ assets did not change in any material way as a result of their transfer to the STARS structure. This income was not a benefit of the transaction.

Turning to subjective economic substance, the Court rejected BNY’s claim that the STARS structure was used to obtain “low cost financing” from Barclays, since the loan was “significantly overpriced and required BNY to incur substantially more transaction costs than similar financing available in the marketplace.”

The Court found lacking BNY’s claim that the STARS structure was needed to give Barclays adequate security for the loan. Not only did Barclays have a security interest in $2.25 billion of high quality securities (independent of the STARS structure), which was 150% of the loan, but BNY effectively guaranteed repayment. Experts for both BNY and IRS testified about structured financing transactions, with BNY’s expert suggesting that STARS served this function. The Court found that the “common indicia of a structured financing transaction are not present in STARS.” Loan proceeds were not used to purchase specific assets, Barclays did not have a security interest in assets acquired with the loan proceeds and the STARS structure did not serve to efficiently reallocate risk. In fact, without STARS, Barclays made a loan that was overly secured with full recourse against BNY. Given the level of security and the full recourse feature, STARS did nothing to reallocate risk. The Court concluded that STARS served no significant banking, commercial or business function with respect to the loan and, thus, did not bear a reasonable relationship to the loan. According to the Court “this lack of reasonableness indicates BNY’s true motivation – tax avoidance.”

The Court also rejected BNY’s claim that the STARS structure provided “low cost” financing. Absent a “spread” feature, the interest rate on the loan was above market rates to a borrower like BNY. Taking into account transaction costs, even with the spread, the loan was above market rate. This negated BNY’s “low cost financing” argument.

The Court next turned to BNY’s argument that taken as a whole, the transaction had economic substance, which it found also wanting. This turned on BNY’s claim that the entire transaction was entered into to obtain low cost financing. This argument failed, since the financing was not low cost.

As to BNY’s argument that the foreign tax credit it claimed was what Congress intended, the Court found “the STARS transaction was a complicated scheme centered around arbitraging domestic and foreign tax law inconsistencies.” It was not the type of transaction for which Congress intended the foreign tax credit.

Finally, the Court disallowed the deduction of transaction expenses, since they were incurred in a transaction that lacked economic substance and held that since STARS was disregarded for U.S. tax purposes, BNY was correctly treated as the owner of the assets and the income from those assets was U.S. source income of BNY. The Court ordered entry of a decision in favor of respondent. Since the Court did not discuss penalty, it can be assumed that the IRS did not propose any penalty against BNY under §6662.

Another case involving a shelter with a cute name and a sophisticated taxpayer is Crispin v. Commissioner, ___ F.3rd ___ (3rd Cir. 2/25/2013), which addressed whether a taxpayer was entitled to deduct losses du
e to his participation in a Custom Adjustable Rate Debt Structure (CARDS). The Tax Court held that the taxpayer could not deduct losses from the transaction and was liable for penalties and the Third Circuit affirmed.

The taxpayer is a CPA who had previously served as chief financial officer of an energy company. He was experienced in both tax matters and tax shelters. During the years in issue, he conducted his affairs through an S corporation that engaged in leasing, structured financing, aircraft acquisition and investing in mortgage-backed securities. He conducted an aircraft leasing business through another entity.

As described by the court, CARDS is “a taxavoidance scheme that was widely marketed to wealthy individuals.” The steps to a CARDS transaction are:

  1. A “tax-indifferent party” (usually a foreign entity) that is not subject to US tax borrows foreign currency from a foreign bank.
  2. A U.S. taxpayer “purchases” a small percentage of the foreign currency by assuming partial liability for the loan.
  3. The taxpayer agrees to be jointly and severally liable with the tax-indifferent party for the entire loan and purports to have basis in the currency he “purchased” equal to the entire amount borrowed by the tax-indifferent party.
  4. The taxpayer exchanges the foreign currency for US dollars and claims a loss equal to the excess of his claimed basis over the dollars received.

Like Dow and Bank of New York, Crispin claimed that he entered into the CARDS transaction for “financing” purposes, in order for his S corporation to secure a line of credit with which to purchase aircraft. This made no sense to the court, since the foreign banks that engaged in the CARDS transaction required that all currency purchased remain at the bank to collateralize the loan and the taxpayer could only get the currency by depositing either cash or a cash equivalent of equal value with the bank.

The year in which the taxpayer claimed the loss was 2001. In Notice 2002-21, issued before the taxpayer filed his 2001 return, the IRS warned against using CARDS and imposed disclosure obligations on promoters and taxpayers who engaged in CARDS transactions. Nonetheless, Crispin used a CARDS transaction to shelter $7 million of income in 2001.

At trial in the Tax Court, the taxpayer testified that he was approached by a promoter, Roy Hahn, at a time when he was planning to have his S corporation purchase aircraft but had not arranged financing. Hahn proposed that the taxpayer enter into a CARDS transaction that Hahn had designed for another client who got cold feet. The specific CARDS transaction involved a 30 year CARDS loan denominated in Swiss francs in which Crispin was to purchase 15% of the foreign currency and agree to be jointly and severally liable for the entire loan. Hahn provided Crispin with a sample tax opinion that blessed the transaction. Crispin’s partner also agreed to participate. The foreign borrower “sold” Crispin 4.8 million Swiss francs and Crispin assumed liability for a $9.4 million in loan. The taxpayer next sold 3.1 million Swiss francs for $1.8 million. The taxpayer used the sale proceeds to purchase a promissory note from the bank, which he deposited with the bank to secure his obligation. One year later, the bank terminated the loan and the security was used to repay the loan.

Shortly before filing his 2001 return, Crispin obtained a favorable opinion letter from a Philadelphia law firm that had written opinion letters for other clients of Hahn. According to the letter, the transaction would ultimately be respected because of the taxpayer’s “business purpose” in seeking to obtain long-term financing. The letter noted IRS Notice 2002- 12 and the possibility of penalties, but gave a more likely than not opinion.

On appeal, Crispin argued that the Tax Court erred because it failed to credit his testimony that he had a business purpose for engaging in the CARDS transaction. The Third Circuit rejected this claim, since there was ample evidence to support the Tax Court’s determination and it was not an abuse of discretion for the Tax Court to discredit the taxpayer’s testimony. Further, the Tax Court correctly found that the transaction was of no consequence to the taxpayer other than generating tax deductions. Thus, the Tax Court did not err in determining that the transaction lacked economic substance.

The Third Circuit has lined up with the majority of other circuits in holding that where a tax benefit is disallowed because it is an integral part of a transaction lacking economic substance; the 40% gross valuation misstatement penalty applies. The Court stated that there were two ways to look at the basis determination, both of which justified the 40% penalty. The first was to look at the cost to the taxpayer to enter into the transaction ($1.8 million) and compare it to the basis claimed ($9.4 million). The second was to view CARDS as two separate but closely related transactions: a purchase and exchange of foreign currency and an agreement to be jointly and severally liable for the amount of the loan in excess of the transaction. Since the liability agreement lacked economic substance, the basis was zero, so the overstatement was infinite. Regardless of which method was used, there was a misstatement in excess of 400%.

The Third Circuit rejected Crispin’s argument that the reasonable cause exception applied. Crispin was aware of Notice 2002-12 and as a CPA and former CFO he understood the warning. The opinion letter was based on Crispin’s misrepresentations to the law firm about his business purpose. Since he relied on advise based on his own misrepresentations, his reliance on the opinion letter was neither reasonable nor in good faith. The Court concluded:

Crispin gambled at CARDS and lost and he is liable for both the underpayment of his taxes and the accuracy-related penalty as determined by the Commissioner.

We now turn to a case about someone who got into a “sham tax avoidance system” and was convicted of three counts of tax evasion (26 U.S.C. §7201) and one count of interference with the Internal Revenue laws (26 U.S.C. §7212(a)): United States v. Scheuneman, __ F.3rd ___ (7th Cir. 4/5/2013). Unlike the taxpayers in Dow, Bank of New York or Crispin, the taxpayer was not a knowledgeable, sophisticated corporation or businessperson. He was a carpenter who, after years of paying his taxes, purchased his tax plan from an Arizona company that set up a limited liability company (Larch Management LLC) and two bogus foreign trusts (Soned Group and Jokur Enterprises). Starting in 1999, Scheuneman operated a construction business through the LLC. The LLC filed returns that reported the two trusts as its sole partners to whom all income was allocated. Between 2001 and 2005, however, Scheuneman wrote approximately $300,000 in checks made to cash on the LLC account and pocketed the money himself.

In early 2004, the IRS learned of Scheuneman through an investigation of the company that set up his entities. It wrote the taxpayer a letter advising him to file correct and proper returns in the coming filing season (2004). Scheuneman wrote back that he was not involved in any type of abusive type of tax scam and now knew what to avoid. He did not file any tax returns for 2003, 2004 or 2005 and began sending frivolous letters to the IRS. Eventually, in late 2005, the IRS informed him that he was under criminal investigation. He failed to appear and produce records in response to a summons. In 2009 he was indicted for tax evasion for 2003, 2004 and 2005. The alleged combined taxable income in the three years that Scheuneman failed to report in these three years was under $200,000 and the combined tax loss for the three years was just over $48,000. Scheuneman was convicted.

At sentencing, the court considered as relevant conduct Scheuneman’s unpaid tax for 2000 and 2001 ($35,000), sentenced Scheuneman to 36 months imprisonment followed by 3 years of probation and ordered him to pay restitution
equal to the tax owed for 2000 through 2005 ($84,382). Scheuneman appealed, challenging the indictments as insufficient because they failed to state all of the elements of tax evasion due to clerical errors as to the due date of the returns. Scheuneman had not raised these objections at trial so the court stated the indictment was immune from attack unless he could show that it was so “defective as to not charge the offense by any reasonable construction.” An indictment meets these requirements if it “(1) contains the elements of the offense charged; (2) sufficiently apprises the accused of what he must be prepared to meet; and (3) enables the accused to plead a judgment under the indictment as a bar to any subsequent prosecution for the same offense.” The court found that, despite clerical errors, the indictment was sufficient to meet these requirements.

The court also held that the date discrepancy did not constitute plain error, since it informed Schueneman a) that 2003 and 2004 were years where he had a tax obligation, b) of the amount of unreported taxable income and c) that he evaded tax for those years by failing to report his income on his tax return. Given the “overwhelming” volume of evidence of guilt, the error was harmless.

Having rejected the variance claims, the court turned to Schueneman’s claim that the district court erred by including 2000 and 2001 in relevant conduct. The court noted that to prevail on this claim, Schueneman must “(1) show that the district court erred in imposing the restitution obligation; (2) the error was obvious or clear; (3) the error affected Scheuneman’s substantial rights; and (4) the error seriously affected the fairness or public reputation of the judicial proceedings.”

Although 2000 and 2001 were not years for which he was charged with tax evasion, the court held that they were “relevant conduct” for purposes of the interference count under §7212(a). The interference count related to a period that began prior to 2004 and continued until at least late 2007. At trial the Government claimed that his interference began in 1999, when he purchased the sham entities and began conducting his business through them in order to hide his income from the IRS and that his interference included preventing the IRS from collecting tax he owed for those years. Given these facts, the court held that it was not error to include tax owed for 2000 and 2001 in imposing the restitution amount.

Robert S. Horwitz, Esq.

Law Offices of A. Lavar Taylor
6 Hutton Center Dr., Ste. 880
Santa Ana, CA 92707

Note From The Editor

Tax Network is published quarterly.

Editor: Joseph P. Wilson, Esq.

Editor’s Note

In my second to last edition of the Cal Tax Network Newsletter, I thought it might be fun to mix it up and share some tax quotes to brighten the read:

“The difference between tax avoidance and tax evasion is the thickness of a prison wall.”

– Denis Healey

“The hardest thing to understand in the world is the income tax.”

– Albert Einstein

“Next to being shot at and missed, nothing is really quite as satisfying as an income tax refund.”

– F. J. Raymond, humorist

“When there is an income tax, the just man will pay more and the unjust less on the same amount of income.”

– Plato

“The income tax created more criminals than any other single act of government.”

– Barry Goldwater

“People who complain about taxes can be divided into two classes: men and women.”

– Unknown

Taxation with representation ain’t so hot either.”

– Gerald Barzan

“For if you love those who love you, what reward have you? Do not even the tax collectors do the same?”

– Jesus Christ

Of course, these quotes reflect the opinions of their authors. Their inclusion here is not an official endorsement of the sentiments expressed. That said, I sure do like them and hope you do too.

This publication is designed as a discussion vehicle for professionals. The ideas presented herein should be researched independently and adequately, and not relied upon. This publication is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the service of a competent professional should be sought.

Form 1099 Max Penalty Comparison:
VSCP 1099 max penalty$500-$10,000 depending on the number of non-filed Forms 1099
General Form 1099 Penalty Calculation$250,000 to $1,500,000 or $75,000-$500,000 if small business
Committee Roster:ChairDavid Warren Klasing
Attorney at Law & CPA
The Tax Law Offices of David W. Klasing
2372 Morse Avenue
Irvine, CA 92614
Tel: 949-681-3502
Fax: 949-681-3504First Vice Chair & SecretaryAttorney at Law
Law Offices of Patrick Crawford
1801 Century Park East
24th Floor, Suite 2400
Los Angeles, CA 90067
Tel: 310-488-5514
Fax: 424-288-4012Second Vice Chair & EditorJoseph P. Wilson
Attorney at Law
Law Offices of A. Lavar Taylor
6 Hutton Center, Suite 880
Santa Ana, CA 92627
Tel: 714-546-0445
Fax: 714-546-2604
Past Committee Chairpersons:2012 Michel R. Stein
2011 Robert Horwitz
2010 Michael R.E. Sanders
2009 Kornelia Davidson
2008 LaVonne D. Lawson
2007 Cathy Stahler
2006 Joseph A. Broyles
2005 David B. Porter
2004 Steve Blanc
2003 Edward T. Perry
2002 Abraham Brown
2001 Dennis Perez
2000 Dennis Brager
1999 Woody Rowland
1998 Judy Hamilton
1997 Charlene Woodward
1996 David Lee Rice
1995 R. Todd Luoma
1994 A. Lavar Taylor
1993 Jennifer Miller Moss
1992 Evan Smith
1991 Mark Ericsson
1990 Jennifer Miller Moss
Send Your Tax Network Submissions To:Joseph P. Wilson
Attorney at Law
Law Offices of A. Lavar Taylor
6 Hutton Center, Suite 880
Santa Ana, CA 92627
Tel: 714-546-0445
Fax: 714-546-2604Submission Due Dates:August Issue: July 18, 2013
November Issue: October 18, 2013
February Issue: January 18, 2014
May Issue: April 17, 2014


* As with all amendments promulgated but not yet submitted to Congress, authority to make technical and conforming changes may be exercised and motions to reconsider may be made. Once submitted to Congress, the official text of the amendments as submitted will be posted on the Commission’s website at and will be available in a forthcoming edition of the Federal Register. An updated “reader-friendly” version of the amendments as submitted to Congress will be posted on the Commission’s website at Back

1 518 U.S. 81, 113 (1996). Back

2 514 U.S. 220 (2005). Back

3 Rita v. United States, 551 U.S. 338, 351 (207); Gall v. United States, 552 U.S. 38 (2007). Back

4 Kimbrough v. United States, 552 U.S. 85 (2007). Back

5 Proposed Amendments to Sentencing Guidelines, January 18, 2013. Back

6 McBoyle v. United States, 283 U.S. 25, 27 (1931) (the principle of fundamental fairness motivates the lenity rule) (Holmes, J.). Back

7 See Enforcement Statistics – Criminal Investigation (CI) Enforcement Strategy , available online at edit?pli=1 Back

8 See Department of Justice Tax Division FY 2013 Congressional Budget, available online at tax-justification.pdf at p. 28. Back

9 IRS statistics are for administrative investigations while DOJ statistics are for both administrative investigations and grand jury investigations. DOJ’s “success rate” is for cases handled by the Tax Division Criminal Enforcement Sections, which prosecute only a small percentage of criminal tax cases. Most criminal tax cases are prosecuted by U.S. Attorney Offices. Back

10 Gall v. United States, 552 U. S. 38 (2007). Back

11 18 U.S.C. 3553(a). Back

12 You should enter into a Kovel agreement with any investigator, accountant, or other person outside your firm to ensure confidentiality. For a good discussion of the need to enter into confidentiality agreements to ensure that the attorney-client and work product doctrines protect the work of these outside professionals, see, Kropf and Blake, “Protecting the Confidentiality of the Work of an ‘Outsider’ On the Defense Team”, 37 The Champion 26 (2013), which is available on Sara Kropf’s website at uments/Confidentiality%20of%20Outsider%20article.pdfBack

13 Not only can this have an impact on the sentencing judge’s evaluation of your client, it may uncover evidence that would show that your client did not act “willfully,” thus negating an essential element of Title 26 crimes. Back

14 The worksheet used by the United States Probation Office for the Central District of California is available at ntakePacketv4.pdfBack

15 This will probably occur if your client went to trial, since prosecutors like to hammer defendants who are convicted after trial, of if the plea agreement leaves open the possibility for the prosecutor to seek enhancements, such as sophisticated means. Under the Ninth Circuit’s recent decision in United States v. Jennings, 2013 U.S. App. LEXIS 6726 (9th Cir. Cal., Apr. 3, 2013), most tax cases could fall under the sophisticated means enhancement. Back

16 IRS Section 530 Back

17 IRC Section 3509(c) Back

18 See IRS Announcement 2011-64, 2012-45 and 2012- 46 for the eligibility requirements and the IRS updates on such requirements Back

19 IRS Announcement 2012-46 Back

20 “Voluntary Classification Settlement Program (VSCP) Frequently Asked Questions,” Self-Employed/Voluntary-Classification-Settlement- Program-(VCSP)-Frequently-Asked-Questions, numbers 17-18 (Dec. 2012). Back

21 “Voluntary Classification Settlement Program (VSCP) Frequently Asked Questions,” http:
// Self-Employed/Voluntary-Classification-Settlement- Program-(VCSP)-Frequently-Asked-Questions
, number 20 (Dec. 2012) Back

22 “Dracut Man Pleads Guilty to Defrauding IRS of $2 Million in Payroll Taxes,” ngTomplea.html. Back

23 Statistical Data Employment Tax Evasion for Three Fiscal Years- Criminal Investigation (CI), Tax-Evasion. Back

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