CPAs at Risk as Government Continues to Attack Abusive Tax Shelters

EXECUTIVE SUMMARY

• Through regulations and other forms of guidance issued since 1999, the IRS has clearly put tax practitioners on notice that it considers tax shelter transactions that generate noneconomic tax losses as not allowable for federal income tax purposes.
• Legislation in 2004 created significant new penalties for the failure to disclose a reportable tax shelter transaction and for an understatement of tax related to a tax shelter transaction.
• In cases involving abusive tax shelter transactions marketed to both business and individual taxpayers, tax practitioners have been severely punished for promoting and selling the transactions and for preparing fraudulent returns based on the transactions.

Tax avoidance can be defined as legally using tax rules to reduce the amount of tax payable by lawful means. Examples of tax avoidance include accelerating tax deductions, deferring income, changing one’s tax status through incorporation, or setting up a charitable trust or foundation. These strategies are often identified as legal tax shelters.

On the other end of the spectrum is tax evasion, which is generally defined as reducing the amount of tax payable through illegal means. Abusive tax shelter transactions typically have no economic purpose other than to reduce taxes with predictable tax losses or tax consequences. Abusive tax shelters fall under the heading of tax evasion.¹ Taxpayers must exercise caution to ensure that their legitimate tax strategies do not evolve into abusive tax shelters promoted purely for the promise of tax benefits with no meaningful change in a taxpayer’s income or net worth.

Many abusive tax shelters became popular in the 1990s among individuals and businesses with one-time large capital gains. At that time, the penalties associated with participating in abusive tax shelters were too small to have a deterrent effect. However, the tide has turned against promoters of such abusive tax shelters. At first promoters of these abusive shelters denied wrongdoing and resisted efforts to settle claims against them, but in recent years a number of important players in the abusive tax shelter industry have either settled or ended up on defense in court. Over time, the courts, the IRS, and various states have responded with statutes, announcements, cases, and procedures and have made it clear that abusive tax shelters are illegal and will be punished with fines, penalties, and/or imprisonment.

The first section of this article covers the rules on tax shelters, the obligation of CPAs to be aware of existing law, and penalties that may be imposed for violating the law. A review of tax shelter cases is presented next. The final section discusses the implications for tax practitioners.

Tax Shelters: Rules, Professional Requirements, and Penalties

Parties involved in the promotion and sale of abusive tax shelters face both civil litigation and criminal prosecution. When tax professionals are accused of participating in suspicious or illegal transactions, they have typically claimed that there were no specific rules forbidding the strategies used and that the transactions were therefore legal. Another tactic commonly used by tax professionals in civil litigation or criminal prosecution has been to deny knowledge of the specific tax rules covering the transaction.

Rules Governing Tax Shelters

It is difficult for CPAs and attorneys to argue that tax shelters without economic substance are legal, given prevailing statutes, Treasury regulations, and IRS rules. The IRS has dealt with the issue numerous times in various forms of guidance, beginning in 1999. The first major notice dealing with tax shelters was Notice 99-59,² in which the Service informed taxpayers that certain types of transactions involving the distribution of encumbered property would not be accepted. Specifically, the introduction of Notice 99-59 alerted taxpayers and their representatives that noneconomic losses generated through tax avoidance transactions are not properly allowable for federal income tax purposes.

Notice 99-59, citing Regs. Sec. 1.165-1(b), states that “[a] loss is allowable as a deduction for federal income tax purposes only if it is bona fide and reflects actual economic consequences. An artificial loss lacking economic substance is not allowable.”³ The notice also warns taxpayers that in addition to disallowing losses from these transactions, the IRS may impose certain penalties on participants or promoters of these transactions, including the Sec. 6662 accuracy-related penalty, the Sec. 6694 return preparer penalty, the Sec. 6700 promoter penalty, and the Sec. 6701 aiding and abetting penalty.

In 2000, the IRS issued a flurry of pronouncements regarding tax shelters. By any reasonable measure, it would be impossible for any practitioner to avoid knowing about these pronouncements. For example, on February 28, 2000, the IRS issued the following six items of guidance in its efforts to regulate and curtail the use of abusive tax shelters:

1. Temporary and proposed regulations requiring the registration of confidential corporate tax shelters under Sec. 6111(d);⁴
2. Temporary and proposed regulations requiring the maintenance of investor lists in investments in certain corporate tax shelters under Sec. 6112;⁵
3. Temporary and proposed regulations requiring corporate taxpayers to disclose on their tax returns investments in certain “reportable transactions” under Regs. Sec. 1.6011-4T;⁶
4. Notice 2000-15,⁷ which identifies 10 different “listed transactions” for purposes of compliance with the above three sets of temporary and proposed regulations;
5. Rev. Rul. 2000-12,⁸ the IRS’s attempt to shut down debt straddle tax shelters; and
6. Announcement 2000-12,⁹ which provides a general description of the new rules and announces the creation of the Office of Tax Shelter Analysis (OTSA) to serve as the focal point of the Service’s efforts to combat abusive tax shelters.

On May 11, 2000, the IRS issued a notice of proposed rulemaking (NPRM) to amend Circular 230, which governs the standards of practice for all practitioners (attorneys, accountants, and enrolled agents) before the IRS.¹⁰ One of the NPRM’s purposes was to warn law and accounting firms that put together tax shelter transactions, as well as the practitioners and chief financial officers who used them, that their professional reputations and fortunes might suffer if the rules were not followed.

In the NPRM, which the IRS also published as Announcement 2000-51,¹¹ the Service requested public comments on its intent to revise these standards, with a particular focus on the proposals to amend the standards under which practitioners operated when preparing and issuing opinions on tax shelters. Later that month, the IRS announced that the OTSA was up and running and was ready to respond to questions as well as to accept tips “relating to potentially improper tax shelter activity by corporate and noncorporate taxpayers.”¹²

Another series of IRS rulings and Treasury warnings was issued in late 2000, including:

1. Notice 2000-60,¹³ which attacked a series of transfers between a parent corporation and its subsidiary designed to create artificial losses for the parent by using employee stock compensation arrangements. The IRS recharacterized the basis transfer from the subsidiary to the parent corporation as a dividend to the parent.
2. Notice 2000-61 (along with a Treasury press release), which disallowed an arrangement in which corporations and individuals had been marketed trusts in Guam on the premise that the trusts would be treated as individuals for tax purposes and that income taxes would need to be paid only in Guam and not in the United States.¹⁴
3. Notice 2000-44,¹⁵ perhaps the most important notice for CPAs involved in the promotion of tax shelters, which warned about arrangements marketed to taxpayers for generating artificial deductible losses. Variations include borrowing at a premium, with a partnership assuming the debt and the taxpayer contributing the proceeds to the partnership, and the taxpayer buying and writing options and creating positive basis in a partnership interest by transferring positions to the partnership. In other words, Notice 2000-44 clearly informed accountants, lawyers, and other professionals across the country that any tax strategy creating an artificially high basis, with no economic substance or business purpose other than to avoid paying tax, was illegal.

The next important set of rules dealing with a specific type of transaction was issued on June 24, 2003, when the IRS issued temporary and proposed regulations addressing the tax treatment of the “Son of Boss” transactions.¹⁶ These transactions involve a partnership’s assumption of certain contingent liabilities contributed by the partner, which, because of the interaction of provisions dealing with the basis consequences of a partnership’s assumption of liabilities, allowed the partner to duplicate or accelerate tax losses. The partner could then use these losses to offset other income. The new temporary regulations deny the partner’s losses by reducing the partner’s basis in the partnership by the amount of the liability.

CPAs’ Professional Requirements

CPAs and tax preparers have a professional duty to be aware of pertinent tax rules regarding transactions on which they offer advice, including any rules contained in IRS notices. This obligation is clearly spelled out in the AICPA Statements on Standards for Tax Services (SSTS).¹⁷ In addition, the courts also have tools at their disposal to address defendants’ claims that they were not aware of the law. One such tool is referred to as the “Jewell instruction” and is covered below.

CPAs must follow the SSTS, which are known as practice standards. Following practice standards is “the hallmark of calling one’s self a professional. . . . Compliance with professional standards of tax practice also confirms the public’s awareness of the professionalism that is associated with CPAs as well as the AICPA.”¹⁸ The SSTS define the professional and ethical tax practice standards for AICPA members.

The courts, the IRS, state accountancy boards, and other professional organizations have recognized and relied on these standards as the appropriate articulation of professional conduct in a CPA’s tax practice. In and of themselves, they have become de facto enforceable standards of professional practice. State disciplinary organizations and malpractice cases in effect regularly hold CPAs accountable for failure to follow these standards.

Standard No. 1, Tax Return Positions, declares that an AICPA member should not recommend a tax return position on any item unless the member has a good-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged. The explanation of this standard reads as follows: “In order to meet the standards contained in paragraph 2, a member should in good faith believe that the tax return position is warranted in existing law or can be supported by a good-faith argument for an extension, modification, or reversal of existing law.” For these purposes, existing law embodies federal and state statutes, Treasury regulations, pertinent court cases, and relevant IRS rulings.

Abusive Tax Shelter Penalties

Criminal penalties: Both taxpayers and preparers accept a certain level of responsibility by signing a tax return. As noted in the Department of Justice CriminalTax Manual, subscribers to tax returns make declarations under penalty of perjury.¹⁹ Accordingly, a person who “willfully makes and subscribes any return, statement, or other document . . . which he does not believe to be true and correct as to every material matter; . . . shall be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 3 years, or both, together with the costs of prosecution.”²⁰ “Willfulness” has been defined as “a voluntary, intentional violation of a known legal duty.”²¹

CPAs and lawyers sometimes claim ignorance of relevant tax rules and statutes as a defense against the willfulness element. In fact, the Criminal Tax Manual specifies that a defense to a finding of willfulness is that the defendant was ignorant of the law or of facts that made the conduct illegal.²² However, it also states that courts have held that “if a defendant deliberately avoids acquiring knowledge of relevant facts or laws, then a jury may infer that he or she actually knew about them and was merely trying to avoid giving the appearance (and incurring the consequences) of knowledge.”²³ In such a case, the court may give an instruction (commonly referred to as a “Jewell” or “ostrich” instruction) to the jury that it is allowed to make this inference.²⁴ Accordingly, CPAs and attorneys have a duty to know and understand tax rules governing any tax shelters they promote. Tax professionals who claim ignorance of basic rules create an ideal scenario for the application of a Jewell instruction in court.

Civil penalties: The American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), imposed substantial new penalties on tax shelter–related transactions. The AJCA created a penalty that applies to a person who fails to disclose on a return or statement any required information about a reportable transaction. The penalty applies whether or not the transaction resulted in an understatement of tax and is in addition to any accuracy-related penalty.²⁵ The amount of the penalty is $10,000 for individuals and $50,000 for all others ($100,000 and $200,000, respectively, for failure to disclose a listed transaction). The AJCA also created a 20% accuracy-related penalty that applies to adequately disclosed reportable transaction understatements. The 20% penalty can be waived if the taxpayer acted in good faith and meets a strengthened reasonable cause exception. The penalty jumps to 30% for understatements with respect to reportable transactions that are not adequately disclosed and it cannot be waived.²⁶

State penalties: California passed legislation in 2003 that imposes several penalties affected by the disclosure of reportable transactions. However, the noneconomic substance transaction understatement penalty does not depend on whether a transaction is reportable. The basic penalty under California Revenue and Taxation Code (CRTC) Section 19774(a) is 40% of the noneconomic substance transaction understatement for any tax year. However, under CRTC Section 19774(b)(1), the penalty drops to 20% if the transaction is adequately disclosed with the taxpayer’s return. In either case, the consequences of noncompliance are very serious for taxpayers in California.²⁷

Court Cases Involving Abusive Tax Shelters

The Department of Justice (DOJ) has announced that it will aggressively pursue participants in fraudulent shelters. According to Assistant Attorney General Eileen J. O’Connor of the DOJ’s Tax Division, “People who participate in tax fraud schemes, including preparing fraudulent tax returns, should expect to be prosecuted, convicted, and sentenced to substantial time in jail.” Nancy Jardini, IRS Chief, Criminal Investigation, has stated, “Accountants should be the pillars of our system of taxation, and we simply can’t tolerate flagrant abuse of the law.”²⁸

As illustrated in the exhibit, the number of cases referred to the DOJ for prosecution by the criminal investigation division of the IRS has also increased in recent years. While the number of investigations declined between 2002 and 2006, the rates of prosecutions, indictments, and convictions all doubled over this period. In addition, the incarceration rate has remained steady at more than 80%. These statistics reinforce the point that tax evasion is a risky crime. Tax evasion convictions are a felony and may be punishable by five years imprisonment and a $250,000 fine.²⁹

The fallout from tax shelter prosecution and litigation has taken a heavy toll on some major players in the tax shelter industry. On April 1, 2007, the IRS announced that the law firm of Jenkens & Gilchrist was dissolving and that their promotions of tax shelters were to blame.³⁰ The firm will pay a $76 million settlement. The firm will not be prosecuted, but former members of the firm are still subject to prosecution.

On February 8, 2007, it was announced that Deutsche Bank had settled lawsuits with more than 300 investors over its role in selling aggressive tax strategies.³¹ David Deary of Montgomery DeFeo & Canada in Dallas, lead counsel for investors involved in the settlement, previously led negotiation of a landmark settlement agreement between Jenkens & Gilchrist and more than 1,000 clients over the firm’s role in promoting tax shelters such as COBRA transactions.³² The cases to be dismissed under the settlement agreement—the terms of which have not been disclosed—represent a large portion of the outstanding cases against the bank over its shelter activity, but it still faces civil suits from other plaintiffs.

The government has also had some success in prosecuting individual players in the abusive tax shelter industry. For example, a former executive of the Munich-based bank HVB pleaded guilty to fraud, conspiracy, and tax evasion charges, marking the federal government’s first criminal conviction in its investigation of allegedly fraudulent tax shelters.³³ The charges against Domenick DeGiorgio could land the accountant in prison for 12 to 15 years under federal sentencing guidelines, federal prosecutors said at the hearing in U.S. District Court in Manhattan. From 1996 through 2003, DeGiorgio was a managing director at the New York branch office of HVB (formally known as Bayerische Hypo- und Vereinsbank AG). He had been responsible for supervising HVB’s participation in various shelter transactions that helped wealthy individuals claim more than $1.3 billion in fake tax losses, according to court documents filed by prosecutors.³⁴

In March 2006, former KPMG tax partner David Rivkin also pleaded guilty to tax shelter conspiracy and tax evasion charges in the case.³⁵ In addition, a federal judge denied a motion by Jeffrey Eischeid to dismiss conspiracy and tax evasion charges against him due to KPMG’s deferred-prosecution agreement in the case. In August, KPMG agreed to pay $456 million as part of the deferred-prosecution agreement, in which it admitted to committing fraudulent conduct in the design and marketing of certain tax shelters.³⁶ Eischeid formerly headed KPMG’s Innovative Strategies Group, which designed and marketed tax shelter products for individual clients. Prosecutors say he helped wealthy individuals avoid paying billions of dollars in federal taxes. Eischeid argued in part that KPMG’s deferred-prosecution agreement with the government violated his right to a fair trial because it required KPMG to express the government’s view of the tax shelter transactions as fraudulent and deprived him of the ability to establish his defense. The court found Eischeid’s argument “unpersuasive.”³⁷

The IRS has also successfully pursued practitioners promoting and selling smaller scale abusive tax shelters to individual taxpayers. Accountants belonging to Anderson’s Ark & Associates (AAA) were prosecuted for their part in the promotion and sale of fraudulent tax and investment schemes, including the filing of false tax returns.³⁸ From 1996 through 2001, AAA clients involved in the schemes reported fraudulent income tax deductions in excess of $120 million. In 2004 and 2005, 10 accountants were convicted or pled guilty to charges in the case and were sentenced to prison terms.

Implications for Tax Practitioners

Individuals across the nation have lost millions of dollars as a result of abusive tax shelters they were convinced to purchase by overzealous promoters. A number of civil legal actions have been brought by taxpayers against the promoters of these tax shelters, and criminal prosecutions have been brought by the government. Several major players such as Deutsche Bank and Jenkens & Gilchrist have paid large settlements to avoid further litigation and prospective penalties, and there have been numerous convictions stemming from the abusive tax shelters. Injured parties are now bringing actions against CPAs for their role in these tax shelters. While the number of investigations by the IRS Criminal Investigation Division has remained constant, the numbers of prosecutions, indictments, and convictions have doubled in recent years. In fact, the list of CPAs who have been convicted of fraud in the aftermath of the abusive tax shelters has been growing steadily.

The results of the cases from the abusive tax shelter industry should serve as a reminder for attorneys and CPAs that there is a fine line between legitimate tax avoidance and illegal tax evasion. CPAs and other tax practitioners should understand that the Service will not hesitate to impose certain penalties on both participants in and promoters of abusive tax shelters. Such penalties could include the accuracy-related penalty under Sec. 6662, the return preparer penalty under Sec. 6694, the promoter penalty under Sec. 6700, and the aiding and abetting penalty under Sec. 6701. In addition, a number of CPAs are now facing tax fraud charges in court, and more will surely be indicted in the future. In addition to penalties, these tax fraud convictions can also lead to prison incarceration, home confinement, or electronic monitoring. These developments should send a clear signal to practitioners that the line between tax avoidance and tax evasion should not be crossed. The risk of fines and imprisonment for promoting abusive tax shelters may no longer be hypothetical.

For more information about this article, contact Prof. McGowan at mcgowanjr@slu.edu.

Notes

¹ Tax evasion usually entails taxpayers deliberately misrepresenting or concealing the true state of their affairs to the tax authorities to reduce their tax liability and includes, in particular, dishonest tax reporting (such as declaring less income, profit, or gain than actually earned or overstating deductions). Moreover, tax evasion is a crime in almost all countries and subjects the guilty party to fines and/or imprisonment.

² Notice 99-59, 1999-2 CB 761.

³ This principle has been upheld by the courts. See ACM Partnership, 157 F3d 231 (3d Cir. 1998), cert. denied, 526 US 1017 (1999); Scully, 840 F2d 478 (7th Cir. 1988); Shoenberg, 77 F2d 446 (8th Cir. 1935).

⁴ TD 8876; REG-110311-98.

⁵ TD 8875; REG-103736-00.

⁶ TD 8877; REG-103735-00.

⁷ Notice 2000-15, 2000-1 CB 826.

⁸ Rev. Rul. 2000-12, 2000-1 CB 744.

⁹ Ann. 2000-12, 2000-1 CB 835.

¹⁰ REG-111835-99.

¹¹Ann. 2000-51, 2000-1 CB 1141.

¹² Ann. 2000-55, 2000-1 CB 1268.

¹³ Notice 2000-60, 2000-2 CB 568.

¹⁴ Notice 2000-61, 2000-2 CB 569.

¹⁵ Notice 2000-44, 2000-2 CB 255.

¹⁶ TD 9062 (6/24/03).

¹⁷ Available at http://tax.aicpa.org/Resources/Professional+Standards+and+Ethics/
Statements+on+Standards+for+Tax+Services/. The standards are issued by the Tax Executive Committee and the AICPA.

¹⁸ AICPA, Statements on Standards for Tax Services, preface, p. 5.

¹⁹ Criminal Tax Manual Section 12.04, available at www.usdoj.gov/tax/
readingroom/2001ctm/index.htm.

²⁰ Sec. 7206.

²¹ Cheek, 498 US 192, 200 (1991).

²² Criminal Tax Manual Section 12.09[1].

²³ Id. Section 12.09[5], citing Dykstra, 991 F2d 450, 452 (8th Cir. 1993), and Ramsey, 785 F2d 184, 189 (7th Cir. 1986).

²⁴ Bussey, 942 F2d 1241, 1246 (8th Cir. 1991); DeFazio, 899 F2d 626, 635 (7th Cir. 1990); and Jewell, 532 F2d 697 (9th Cir. 1976). In Jewell, the defendant was convicted of transporting marijuana in his car from Mexico to the United States, but he deliberately avoided obtaining positive knowledge as to whether marijuana was present in his vehicle. The court held that the government can complete its burden of proof by proving, beyond a reasonable doubt, that if the defendant was not actually aware that there was marijuana in the vehicle, his ignorance in that regard was solely and entirely a result of his having made a conscious decision to avoid learning the truth.

²⁵ Sec. 6707A.

²⁶ Sec. 6662A. See Yang, Jeffers, and Lin, “Abusive Tax Shelters: Heavy Penalties Under the American Jobs Creation Act of 2004,” CPA Journal Online (August 2006), available at www.nysscpa.org/cpajournal/2006/806/essentials/p40.htm.

²⁷ See Salmon and Amitay, “California Taxpayer Disclosure Requirements,” 35 The Tax Adviser (September 2004): 576.

²⁸ U.S. DOJ Press Release, “Two CPAs Sentenced in $120 Million International Tax Shelter Case,” September 16, 2005, available at www.usdoj.gov/opa/pr/
2005/September/05_tax_485.html.

²⁹ Sec. 7201; 18 USC §3571.

³⁰ IRS News Release, IR-2007-71.

³¹ “Deutsche Bank Settles Hundreds of Investor Lawsuits over Fraudulent Tax Shelters,” BNA Daily Tax Report, February 12, 2007, p. K-1.

³² COBRA stands for Currency Options Bring Reward Alternatives. In a COBRA transaction, the taxpayer sells a short option and purchases a long option in identical amounts but with different strike prices on a foreign currency exchange. The taxpayer then contributes the options to a partnership formed for the transaction. When the options expire, the partnership realizes a gain or loss. The taxpayer contributes cash or other assets to the partnership. The taxpayer then contributes his or her interest in the partnership to an S corporation formed for that purpose. The partnership terminates. The S corporation then sells the contributed assets. Because the basis of the taxpayer’s interest in the partnership is increased by the purchase cost of the long option but not decreased by the premium earned on the sale of the short option, on the S corporation’s sale of its capital assets, the S corporation realizes a large loss, which reduces the taxpayer’s tax liability. Seippel v. Jenkens and Gilchrist, P.C., 341 FSupp2d 363 (S.D. N.Y. 2004).

³³ Douglas, 98 AFTR2d 2006-6307 (N.D. Cal. 2006); and Stein, 97 AFTR2d 2006-740 (S.D. N.Y. 2006).

³⁴ Weil and Scannell, “HVB Ex-Official Pleads Guilty over Tax Shelter,” Wall Street Journal, August 12, 2005, p. A3.

³⁵ “Former KPMG Tax Partner Pleads Guilty to Tax Evasion, Conspiracy,” 2006 TNT 59-3, Doc. 2006-5864 (March 28, 2006).

³⁶ 2005 TNT 167-15, Doc. 2005-17993 (August 29, 2005).

³⁷ “Judge Denies Motion of KPMG Ex-Partner,” Wall Street Journal, April 5, 2006, p. 1. However, charges were later dropped against Eischeid and a majority of the other defendants in the case because the court held that the government had violated the defendants’ constitutional rights by using its influence to cause KPMG to discontinue paying for the costs of their defense. “Federal Judge Dismisses Fraud Indictment Against Majority of KPMG LLP Defendants,” BNA Daily Tax Report, July 17, 2007, p. K-1.

³⁸ U.S. DOJ Press Release, “Two CPAs Sentenced in $120 Million International Tax Shelter Case,” September 16, 2005.