No Fraud Penalty for Taxpayer Who Entered Into Tax Shelter Deals Jacoby, TC Memo 2015-67 The Tax Court has ruled that a taxpayer who entered into a "Midco transaction" to convert ordinary income into capital gain income, and who took deductions based on a questionable tax-favored investment product, significantly understated his tax liability but had none of the badges of civil fraud. When shareholders who own stock in a C Corp that in turn holds appreciated property wish to dispose of the C Corp, they can do so through one of two transactions: an asset sale or a stock sale. In an asset sale, the shareholders cause the C Corp to sell the appreciated property (triggering a tax on the built-in gain) and then distribute the remaining proceeds to the shareholders. In a stock sale, the shareholders sell the C Corp stock to a third party. The C Corp continues to own the appreciated assets and no built-in gain tax is triggered. In other words, in an asset sale, a C Corp's sale of its assets imposes an additional tax liability. In the case of a stock sale, the assets remain owned by the C Corp and the tax on the built-in gain is not triggered. But, buyers would generally prefer to purchase the assets directly and receive a new basis equal to the purchase price, thus eliminating the built-in gain. "Midco transactions" are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or "Midco"). The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets. The Midco's willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on Midco's taxexempt status or tax attributes, such as losses, that allow it to absorb the built-in 1
gain tax liability. IRS has said that it may challenge the purported tax results of a Midco Transaction on several grounds. ( Notice 2001-16, 2001-1 CB 730 ) If any part of any underpayment of tax required to be shown on a return is attributable to fraud, Code Sec. 6663(a) imposes the civil fraud penalty. IRS bears the burden of proving fraud by clear and convincing evidence. ( Code Sec. 7454(a) ) To satisfy its burden, IRS must show: (1) an underpayment of tax exists, and (2) that the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. (Parks, (1990) 94 TC 654 ) Courts have developed a nonexclusive list of factors, or "badges of fraud," that demonstrate fraudulent intent. These badges of fraud include:... understating income,... maintaining inadequate records,... implausible or inconsistent explanations of behavior,... concealment of income or assets,... failing to cooperate with tax authorities,... engaging in illegal activities,... an intent to mislead which may be inferred from a pattern of conduct,... lack of credibility of the taxpayer's testimony,... filing false documents,... failing to file tax returns,... failing to make estimated payments, and... dealing in cash. (Niedringhaus, (1992) 99 TC 202 ) Although no single factor is necessarily sufficient to establish fraud, the combination of a number of factors constitutes persuasive evidence. 2
The taxpayers were Mr. and Mrs. Jacoby. Mr. Jacoby had a degree in accounting, had worked in an entry level position at a prestigious accounting firm's audit department, then went back to law school where he took a basic income tax course and worked for a law firm. Thereafter, he began his long term career in wealth management. He worked at a wealth management firm then moved to Twenty-First, where he was a licensed securities broker and account executive. His main job was to close deals involving tax-advantaged investments based on strategies developed by other Twenty-First personnel and by outside firms. Jacoby left Twenty-First to form his own business, SMD, an S corporation, in which he played the same role that he did for Twenty-First. He began working closely together with Diversified Group, Inc. (DGI) and its president, Mr. Haber; DGI was one of the firms that developed strategies for Twenty-First. As far as Mr. Jacoby knew at the time, all the transactions entered into by his clients were carefully vetted and approved by DGI, DGI's outside counsel, and the client's counsel. One of the strategies employed by DGI was the Midco transaction. Mr. Jacoby witnessed deals involving sales of companies holding only ordinary assets and at least one deal that involved the sale of an S corporation. He did not witness any deals involving the sale of a company whose only asset was accounts receivable. At a time when SMD's only significant asset was its accounts receivable due from DGI, and DGI was having trouble paying SMD, Jacoby asked Haber whether Haber could set up a Midco transaction whereby, instead of paying off the receivables, DGI would buy SMD for a price that was less than the receivables and Jacoby would have capital gains rather than the ordinary income he would have if SMD collected the receivables. Haber set up this deal, 3
Jacoby had his attorney review it, and the deal went through. Jacoby received monies from the deal in both '99 and 2000. He reported all of the details of the deal to the CPAs who prepared his returns. Jacoby also entered into another deal that had been conceived by DGI-a foreign currency transaction, involving options, which would "secure tax deductions beyond the economic value of the options." The deal was set up by several partners from the KPMG accounting firm. The entity used for the deal was JPF III. During '99, Jacoby transferred $40,000 to the attorney who was handling the JPF III transaction. In December, '99 Jacoby signed an agreement that provided that JPF III was his agent with respect to the JPF III transaction, effective Nov. 15, '99. However, another JPF III document, the contribution agreement, said that there was no agency agreement between Jacoby and JPF III. When Jacoby submitted information about the JPF III transaction to his CPAs, he included a tax opinion that he believed was created by Mr. Acosta, an employee of the law firm that was handling the JPF III transaction. The first page of the opinion said it was prepared by Acosta, but a later section said that the opinion was from KPMG, the accountants who set up the deal. IRS disallowed the results of the SMD and JPF III transactions on the Jacobys' '99 and 2000 returns. The Court found that an underpayment existed but that the civil fraud penalty did not apply. As to the underpayment, the Court said, citing Seward, TC Memo 1961-114, that accounts receivable "cannot be turned into capital gain items by means of a sale." It concluded that IRS had shown by clear and convincing evidence that, as a result of the SMD stock sale, the Jacobys underpaid their tax for the two years at issue. 4
As to the intent to evade, IRS asserted that six of the badges of fraud were present in this case, while the Jacobys argued that none were present. The Court addressed each of the asserted badges of fraud as follows:..the Court noted, citing Korecky, (CA 11 1986) 57 AFTR 2d 86-839, that a "mere understatement of income does not constitute proof of fraud" while a "consistent and substantial understatement of income is by itself strong evidence of fraud." It said that, while there were understatements for the years at issue, IRS did not prove, nor even suggest, that the Jacobys understated their income for any other year. It concluded that IRS failed to prove the existence of consistent and substantial understatements of income....irs's argument was built on three premises: (1) That the SMD stock sale was different from any of the strategies that Mr. Jacoby had previously marketed to the extent it involved the sale of an S corporation whose only asset was accounts receivable. But the Court said that the record showed that Mr. Jacoby had previously witnessed clients engaging in transactions involving S corporations as well as transactions involving entities that held only ordinary income assets-transactions that had been approved by various firms and seemed legitimate at the time. While there were no transactions involving entities whose only asset was accounts receivable, the Court found it plausible that Mr. Jacoby believed the SMD transaction was sufficiently similar to prior transactions to not raise any concerns. (2) That "Mr. Jacoby, on his own and without any outside advice, designed the nominal sale of SMD stock." However, the Court said, Mr. Jacoby came up with the idea for the SMD stock sale after witnessing earlier DGI transactions and spoke with Mr. Haber regarding the legitimacy of the sale before initiating the transaction. Moreover, he fully disclosed the details of the transaction and provided all the documents he had relating to the transactions to his 5
accountants with the expectation that they would report it appropriately on the Jacobys' returns. (3) That Mr. Jacoby had tax expertise. The Court noted that Mr. Jacoby held both an accounting and a law degree and had worked at an accounting firm, a law firm, and several financial services firms. However, it said, on closer examination, Mr. Jacoby's tax credentials were not as strong as they first appeared. While he was hired by a prestigious accounting firm, Mr. Jacoby had no involvement with the tax side of the firm. In law school, he did not specialize in tax law, and he did not have an LL.M. in taxation. When he marketed investment strategies, it was other persons, such as Mr. Haber, who handled the development of the strategies. The Court concluded that IRS did not show, by clear and convincing evidence, that Mr. Jacoby was anything more than a marketer who relied on tax specialists to devise and vet the strategies....irs argued that Mr. Jacoby never invested money in the JPF III transaction, was never a partner in JPF III, and that JPF III never acted as his agent. IRS also argued that even if JPF III had been acting as Mr. Jacoby's agent in the JPF III transaction, the Jacobys' '99 and 2000 tax returns concealed income by hiding the existence of the principal-agent relationship. The Court said that it was unclear from the record whether a principal-agent relationship existed between Mr. Jacoby and JPF III. However, the evidence showed that the Jacobys transferred $40,000 to an account controlled by the JPF III transaction counsel. This led the Court to believe that the Jacobys did invest some amount of money in the JPF III transaction. The Court said that, in any case, it appeared that Mr. Jacoby believed a principal-agent relationship existed and provided his accountants with all the documents relevant to the transaction. Moreover, IRS did not cite any authority 6
in support of its argument that the Jacobys were required to disclose any principal-agent relationships on their returns. The Court said it could not conclude that the Jacobys concealed that information....irs pointed to the following as false documents filed with IRS: the Jacobys' '99 and 2000 Federal income tax returns, the backdated agency agreement with JPF III, and the different versions of the tax opinion. The Court said, regarding the agency agreement, that there is a distinction between an effective date provision seeking to memorialize a prior oral agreement and an attempt to backdate an agreement in order to retroactively obtain an unwarranted tax benefit. The agency agreement merely stated that it was "made effective" as of Nov. 15, '99. The Court said that the fact that the contribution agreement stated that JPF III was not acting as an agent raised serious concerns as to the legitimacy of the agency agreement. Nevertheless, there was no indication that Mr. Jacoby was aware of the contribution agreement or the discrepancy between it and the agency agreement. Thus, IRS failed to show, by clear and convincing evidence, that Mr. Jacoby knew that the agency agreement was false or that he submitted it with an intent to mislead. As to the tax opinion, the fact that Mr. Acosta did not draft it was a concern; however, there was no indication that Mr. Jacoby was aware of the discrepancy in authorship. And, the Court said that the questions regarding the authorship of the tax opinion did not render the tax opinion fraudulent....irs also argued that two other badges of fraud existed-failure to cooperate, and a pattern of behavior indicating an intend to mislead-but the Court disagreed. Thus, the Court found no badges of fraud and ruled that the civil fraud penalty did not apply. 7