Originally published on Forbes.com.
The legal fallout from the “X-Rated” tax shelters first exposed by Janet Novack and Laura Saunders in 1998 seems never-ending. This week’s decision BCP Trading and Investments LLC by Judge Holmes is on a petition filed in 2008 and concerns tax savings from 2000 to 2002. Judge Mark Holmes is noted for his clear writing and he really shows it in this decision. Featured in the decision are four individual taxpayers who participated in the shelter designed by EY. (In order to avoid prosecution for this and other shelters EY ended up paying the government $123 million in 2013.) The four individuals are Kevin Kalkhoven and Danny Petit, formerly of JDS Uniphase Corporation, and William Esrey and Ronald LeMay, formerly of Sprint Corporation.
Judge Holmes starts out by indicating the high stakes and also gives a hint as to how things will go in his first sentence. “These cases are about a purported partnership that used almost perfectly offsetting bets on foreign currency to pass over $3.3 billion of tax losses through to its partners—partners who contributed only $16.5 million”. The hint is the use of the word “purported”. Anytime you see any form of the word “purport” in a decision, you can be pretty sure things are not going to go well for the taxpayers. This case is no exception.
What They Were Up To
The plan, called CDS Plus, was the outgrowth of another plan CDS (Contingent Deferred Swap) that had been put together by EY’s VIPER group (Value Ideas Produce Extraordinary Results). The authors of Confidence Games: Lawyers, Accountants, and the Tax Shelter Industry devote a couple of chapters to VIPER noting that inside the firm the “R” stood for Revenues rather than results. The original CDS was a plan that deferred income and converted it to capital gains. CDS Plus was designed to eliminate the resulting capital gain income entirely.
I have gotten criticism occasionally for my blog being too wonky, Sadly there is no way to explain CDS Plus, which is kind of a variation of Son of Boss without getting a little wonky. You can skip the next couple of paragraphs if you don’t care.
I had a hard time figuring these deals out because they are fundamentally based on something that is anathema to me and the vast majority of the 600,000 or so CPAs in the United States not to mention numerous other accountants. Unbalanced entries.
There is an old accounting joke about a fellow who came to work every day, opened his desk drawer, looked at a slip of paper, closed the drawer, and went to work. Everybody was curious about the mysterious piece of paper, but they respected his privacy. Finally, though, somebody broke down and took a peek. On the paper was written “Debit by the window. Credit by the Door”.
Debits have to equal credits. Assets have to equal the claims against assets (i.e. liabilities and equity). It has to balance. Accountants get so fanatical about this, that they sometimes confuse things being balanced with things being right. You can be in balance and things can still be wrong, but it can never just be one thing. The discipline of double-entry means that a mistake in one area will also crop up someplace else as long as you are in balance. Scoundrels hate the discipline of double entry.
Build Your Own Shelter
CDS Plus, like the Son of Boss deals that it resembled, had, at its heart an unbalanced entry. It was “Debit by the window. Credit out the window.”
When you write an option, you get tax-deferred cash. If the option expires worthless, you have income. If it is exercised, you will have a gain or a loss depending on how much you have to go out of pocket to perform. When you buy an option you pay money which gives you a basis in the option.
When you put property into a partnership, your basis in your partnership interest is increased by your basis in the property. When you get a liquidating distribution from a partnership your basis in the distributed property is your basis in your partnership interest. Got all that? Good. Now you can do your Son of Boss Deal.
Write an option where you guarantee that you will sell Japanese yen at $0.0099 in a year. How many yen? Well, how big a tax loss do you want? $5 million? OK, whatever it needs to be so the option is worth $5 million. Now you are going to use that $5 million-plus let’s say a hundred thousand to buy an option to buy Japanese yen in a year at $0.0098. Of course, you don’t get to actually handle that $5 million because both transactions are with the same counterparty. I don’t design these things, so there may be some weaknesses in the example I just constructed. Regardless, the next step is to put the option pair into a partnership.
Here is where the magic comes in. Maybe you went out of pocket by $100,000 for the option pair, but, in theory, you “paid” $5 million for the second “long” leg, so your basis in that is $5 million. The first “short” leg is a contingency; you don’t count it as a liability assumed by the partnership. So your basis in your partnership interest is $5 million. The options will pretty well cancel one another out in a year and you will end up with a few thousand dollars worth of Japanese yen. When you liquidate the partnership the $5 million basis gets transferred to the yen, which you then sell at a loss of about $5 million. That $5 million in basis you are writing off was created out of thin air with an unbalanced entry where the credit was thrown out the window.
Go to the decision and read how Judge Holmes explains it. It is more eloquent. He graduated from Harvard and the University of Chicago, while I flunked out of the University of Chicago, but I think I am better at debits and credits.
Why They Think They Should Get Away With It
Judge Holmes’s explanation of the taxpayer’s position reminds me of the joke about what you do if accused of murder. You say that you weren’t there, you weren’t the one who did it, it was self-defense and you were insane. In this case, it was that the Tax Court did not have jurisdiction, the IRS caught up with them too late and that the complex transactions were just regular business diversification as opposed to artificial transactions designed to avoid taxes.
The Decision
The jurisdictional argument involves how TEFRA works and I have already given you enough wonkiness so I will pass over that. With respect to the statute of limitations, Form 872-P had been signed by Charles Bolton on behalf of corporate tax matters partners. Bolton pleaded guilty to conspiracy in 2009 in his relation to EY’s VIPER projects and was sentenced to fifteen months in prison and a $3 million fine. The argument is that the first extension for the year 2000 signed by Bolton as TMP was under direction from EY which was already under IRS investigation making for a disabling conflict of interest. Other extensions are blamed on bad advice from EY which was conflicted in ways that the taxpayers were not aware. Those arguments also went nowhere with Judge Holmes noting that there were other advisers involved and indications that the players had a sense of EY’s problems.
In order for the deal to work BCP had to be a valid partnership, because as Judge Holmes puts it “it is only partnership-basis rules that seem to lend themselves to this kind of chicanery “. There is a discussion of a variety of factors, but it gets pretty well boiled down to:
” What we find is a scrupulous adherence to the formal requirements of making BCP look like a partnership, but a complete absence in its operating agreement and actual operations of any objective indication of a mutual combination for the present conduct of an ongoing enterprise. We therefore find that the client members did not intend to “join together” to undertake business under BCP, and that they were not partners in this purported partnership.”
This is something of a restatement of Reilly’s Fourth Law of Tax Planning, which in its original form emphasizes the importance of execution. Here we have “Execution is a lot, but it is not everything”.
The bottom line is that the paired foreign currency options were single option spreads that had basis equal to the amount the partners went out of pocket by. Lower basis means lower losses. How much lower? A bit more than a billion dollars.
What Is Next?
I reached out to a couple of the numerous attorneys involved in the case. One responded that they don’t comment on ongoing litigation. Robert E. McKenzie of Arnstein & Lehr, who has also contributed to forbes.com wrote me: “We are disappointed with the opinion and we are evaluating options”. My money is on there being an appeal, but we will see.
There is another interesting piece of litigation related to these matters. Besides all the rest of the tsuris created by these shelters, Mr. Esrey and Mr. LeMay lost their jobs with Sprint because of them. (Perhaps an instance of Reilly’s Second Law of Tax Planning – Sometimes it’s better to just pay the taxes.) They are suing the United States, on the theory that the IRS withheld from them the knowledge that EY was under investigation.
“The IRS knew of EY’s fiduciary duties to Plaintiffs, and of EY’s conflict of interest, but nonetheless helped EY to hide information from Plaintiffs knowing that such information would have been critical to Plaintiffs’ evaluation of whether to trust EY and whether to continue to tell Sprint that EY was trustworthy and devoted to helping Plaintiffs resolve their tax audits with the IRS. The IRS also permitted EY to continue to represent Plaintiffs before the IRS”
Judge James Paul Oetken of the District Court for the Southern District of New York ruled that the complaint did not meet one of the exceptions to sovereign immunity throwing out the claim for $160 million in damages. A notice of appeal was filed on May 17, 2017, so we will be hearing more about these matters in the future.
Other Coverage
Vidya Kauri had a summary on Law 360 titled Tax Court Disallows $3.3B Losses In Partnership Scheme. The $3.3 billion is mentioned in the introduction to the case, but the disallowance at the end is just over a billion. I’m thinking that over two thirds of the losses ended up either being settled or saved by the statute of limitations. I’ll leave that for my commenters to sort out.
Lew Taishoff was going to pass on this case, but I inspired him to take another look. The result was They Were Warned; They Were Given An Explanation; They Persisted. He focused on the issue of the individuals claiming to rely on EY given how early in the process they had lawyered up. Mr. Taishoff gives us a takeaway – ” If you wish to plead your injured innocence, please make sure you lawyer up only after the fact. If you don’t, the weight of those white shoes may sink you without trace.”
Leslie Book at Procedurally Taxing had a similar observation to Lew Taishoff’s – “As we have discussed before it is difficult to argue against a signed consent to extend. The argument in BCP was a long shot, especially given the partners’ sophistication and the less than appealing atmosphere of a reviled tax shelter.”