Originally published on Forbes.com.
The IRS wants over $60 million in tax shelter promoter penalties from John Larson. They are not penalties that can be contested in Tax Court. The requirement is that the penalties be paid and a claim for refund made. If the claim is denied, the taxpayer gets to go to District Court or the Court of Claims. Mr. Larson paid $1.4 million and sued for refund. Judge Valerie Caproni of the US District Court for the Southern District of New York has ruled that Mr. Larson does not get his day in court on the merits of the penalty because he has not paid the whole thing. That seems pretty unfair, so I should be feeling sympathetic to Mr. Larson, but overall I’m feeling schadenfreude. To understand that you need the story behind the story.
The Raid On The Fisc
In the nineties and a bit into the new millennium, major law and accounting firms designed extremely aggressive tax shelters that were marketed to high net worth clients, particularly those experiencing “liquidity events”. Rather than charging clients for their time, the deals were “value billed”. The proposition was fairly simple. You had a very large capital gain. You could pay the government 20% or pay KPMG 3%. Jack Townsend who blogs on federal tax crimes calls the episode “a raid on the fisc”. The story of what was going on was first publicized by Forbes editor Janet Novack in a 1998 piece titled The Hustling of X Rated Tax Shelters.
The whole sad story is documented in Confidence Games – Lawyers, Accountants and the Tax Shelter Industry by Tanina Rostain and Milton Regan. The KPMG national tax office had a group referred to as the “Skunk Works”, a reference to a team of Lockheed engineers who worked on stealth fighters. Tax scholar Calvin Johnson noted the irony
A ‘skunk works’ operation was once a secret research lab for developing planes to defeat the Nazis and Communists. The KPMG tax skunk works dreamed up transactions against our United States.
It strikes me more as part of a lamentable tendency among CPAs to overly dramatize our work, which is clean and involves no heavy lifting or danger I recall the head of our tax group during my brief period with a national firm regularly calling for “All hands on deck” and the head of a group that did capital account studies talking about his people being deployed. When I joined the swelling ranks of the fired, one of the surviving partners referred to me as having been shot.
It Did Not End Well
John Larson, then a manager in KPMG’s San Francisco office, was a regular at skunk works meetings. He and a couple of others developed a plan called FLIP based on the transaction which Seagram Company used to avoid a billion dollar tax bite when it sold Du Pont stock back to Du Pont. FLIP did not structure a sale to avoid capital gain as Seagram did. FLIP (Foreign Leveraged Investment Program) created a capital loss out of close to thin air to shelter another capital gain.
The next step was to found, along with Robert Pfaff , Presidio Advisory Services. Presidio’s principal purpose was to collaborate with KPMG in designing and implementing tax shelters. Two lawyers came up with a new idea called Bond-Linked Issue Premium Structure. They licensed it to Presidio and it was off to the races. According to prosecutors in the 2007 trial (You knew this was not going to end well), Presdio received over $140 million in fees from BLIPS deals.
Where Did The $1.4 Million Come From?
Due to circumstances beyond the scope of this post, John Larson was one of the very few participants who ended up doing time because of all these shenanigans. Being generally aware of these circumstances I was puzzled about how he could have possibly had the $1.4 million that he put up to try to get his day in court. I found a clue in another decision that came down while he was still in prison. Larson had originally been fined $6 million, which he paid. He appealed the fine and a court cut it in half, but the IRS went for a jeopardy assessment on the refund, because they were still not done with him civilly. In the litigation on the jeopardy assessment we get:
Here, the circumstances justified a determination that Mr. Larson appeared to be designing to place the expected three-million-dollar refund beyond the government’s reach. It bears repeating that Mr. Larson has been convicted of tax evasion. He made a profitable business out of designing, implementing, and marketing complex tax-evasion schemes, and he used foreign entities to shelter his profits. After the IRS examined and disallowed one of Mr. Larson’s tax-evasion strategies, Mr. Larson transferred millions of dollars to his trusts in the Bailiwick of Guernsey, where the money could not be reached by the United States government. The district judge who heard Mr. Larson’s criminal case found this transfer to be “a brazen act” justifying an increase in his sentence . That judge also found the trial evidence to show that Mr. Larson had continuing relationships with foreign nationals who helped him hide funds abroad . Mr. Larson recently admitted that he still owns foreign trusts. In short, the record shows that Mr. Larson has the resources, the know-how, and the gall to continue hiding his money from the United States or placing it beyond the government’s reach. The determination by the IRS that Mr. Larson’s expected three-million-dollar refund might well disappear as soon as it is remitted to him was reasonable under these circumstances.
The fact that Mr. Larson currently is incarcerated does not alter this analysis. Even from prison, he can communicate instructions to loyal confederates with control over his assets.
I really don’t envy anybody being in prison, but I have to say that if you have to be in prison having some loyal confederates you can communicate instruction to sounds kind of cool. And if I was going to have a jurisdiction where I could park some ill-gotten gains, having it be a bailiwick is just the thing. Just to be clear, that was from 2011. Mr. Larson is not currently incarcerated.
The Complaint
Which finally brings us to last week’s decision by Judge Caproni. The IRS had notified Larson that he was subject to penalties of $24,745,026 for not registering FLIP and $135,487,056 for not registering BLIPS. There is joint and several liability among promoters for this penalty so IRS gave him credit for payments made by others which is what cut the tab way down to just over $60 million. In the complaint, Mr. Larson’s attorneys complain about the method that the IRS is using to compute the penalties.
The IRS used an unconscionable and illegal method of calculating penalties for non-registration, assessing a mind-boggling $160,232,026 in penalties personally against Mr. Larson merely for not filing two IRS forms.
Here is the part of the complaint that I find really amusing.
In computing the $160,232,026 penalty, the IRS interpreted the “aggregate amount invested”language in 6707(a)(2) to included loans and loan premiums that were never invested by the participants in these transactions. The effect of the inclusion of these loans and loan premiums was to grossly inflate the 1% penalties from approximately $7,000,000 (if the loans and loan premiums were not included) to $160,232,026 (with the inclusion of the loans and loan premiums).
Reading between the lines of the complaint it appears that investors in the aggregate put up $700 million for claimed assets in the $16 billion neighborhood. And it is so unfair to believe in the higher number when it comes to figuring out the penalties, but just fine when losses were being recorded. Mr. Larson also thinks he should have more access to information on the payments by co-promoters. By the way, I’m sure you are wondering about the $56 the total is off by. Sorry, I’m stumped by it too.
No Day In Court
The court does not get to the merits of the complaint because it finds that it does not have jurisdiction. That is what the decision is about. Frankly, it is pretty lawyerly. For that reason, I am turning to Jack Townsend’s Federal Tax Crimes for his analysis. His conclusion is.
I think that the Court gives short shrift to a very serious issue. The holding is that the IRS can make an arbitrary and punitive assessment for a tax or penalty which does not permit the Tax Court prepayment remedy (or have one of the statutory partial payment relief provisions) and thereby preclude a taxpayer from litigating the merits.
When you think about it, there is something really wrong here. By setting the penalty high enough the IRS can avoid judicial review. I’m still only feeling schadenfreude for Larson, but I’m at least feeling a little guilty about it.
Other Coverage
Natalie Olivo had something on Law 360 pointing out the Eighth Amendment argument – something you don’t see a lot in tax litigation.
During oral arguments in December, Larson’s attorney Megan L. Brackney of Kostelanetz & Fink LLP had said that the “$160 million fine for not filing two pieces of paper” was excessive under the Eighth Amendment, making the statute under which he was prosecuted unconstitutional. She said the vagueness of the law allowed for an arbitrary penalty and raised the specter that the IRS could set a penalty “super high” without its ever being subject to judicial review.