Originally published on Forbes.com.
Another day another penalty case from the tax shelters of the turn of the millennium. This one has me a bit torn. I find the taxpayer very sympathetic. It was Corbin McNeill’s role as a utility executive that sent him searching for tax shelter. Mr. McNeill became the chairman and CEO of Exelon when it was formed by a merger in 2000. Exercising stock options when he retired in 2002 had him facing potentially over $66 million in taxable income.
What really impresses me about Mr. McNeill is his first career. He graduated from Annapolis in 1962 and served in the Navy until retirement, at the rank of commander, in 1981. His most notable assignment, to me anyway, was command of USS Tautog SSN-639. I have this fascination with submarine skippers and devour their memoirs, a topic which I never expected to work into this blog, but here it is. Tautog was a Sturgeon-class fast attack submarine. Command of a nuclear submarine and command of the Naval Nuclear Power School convince me that Commander McNeill had an awful lot on the ball.
The DAD Deal
The particular shelter he chose was called DAD (distressed/asset debt). Rather than creating basis out of thin air, like BOSS or Son of BOSS, DAD works by the taxpayer taking advantage of a foreigner’s basis. Worthless receivables are shuffled from one partnership to another. At the end of the chain, Mr.McNeill ended up with an interest in a partnership with over $20 million in basis for $3 million (plus some hefty fees to BDO, which designed the thing). Then he put in other assets to increase his basis in the partnership, in order to be able to take the loss. It strikes me that this is not entirely a free lunch. It would seem that basis in the contributed assets needs to be reduced. Perhaps one uses things that are meant to be held indefinitely.
The Penalty
At this point, everybody is past arguing about whether DAD actually worked. What was before the Tax Court was whether Corbin and Dorice McNeill should pay a 40% penalty on the deficiency on their 2003 return. There were also some procedural issues stemming from the case coming before the Tax Court as an appeal of a collection due process hearing. I’ll leave those for the lawyers.
The McNeills based their argument against the penalty on their reliance on EY (one of the Big 4), which prepared their 2003 return and a letter from a law firm, De Castro, West, Chodorow, Glickfield & Nass, recommended by BDO, which had designed and was aggressively marketing DAD. BDO falls in the class of firms, I call the “not quite Big 4”. DeCastro had been recommended by BDO and charged a fee based on the amount of expected losses from the DAD transaction.
Sadly, Mr. McNeill was witnessing the deprofessionalization of law and accounting firms. One of the hard realities of professional practice is that in order to make money you need to either do some actual work or pay somebody some pretty good money to do the work. The tax shelter opinions were about the most extreme example of rebellion against the tyranny of the billable hour – value billing. The problem with value billing in this arena is that the consequent conflict of interest pretty well eliminates the value of the opinion, as the Tax Court noted in Canal Corporations and Subsidiaries in 2010.
EY
EY was not the value biller in this scenario. EY was just preparing the McNeill tax return. You can’t expect the preparer of an individual return to look through every deal that the individuals are involved in. As it happens, EY did more than usual, but it was not enough for reliance. Most notably it did not include itself as a material adviser on the transaction.
For both 2002 and 2003 EY prepared internal memorandums that briefly analyzed Mr. McNeill’s DAD transactions. In the memorandums EY looked at the transactions for a “realistic possibility of success”. This standard, derived from section 6694(a)(1), relates to imposing penalties on tax return preparers for understating a taxpayer’s liability. EY’s memoranda reflected the standard of review to ensure it would not be penalized for the positions taken on petitioners’ returns—not that they were providing return position advice to petitioners on the DAD transactions. Petitioners did not receive either memorandum and could not have relied upon either. [*30] The Form 8886 included with petitioners’ 2003 personal tax return also demonstrates that Mr. McNeill did not rely on EY for advice concerning the 2003 DAD transaction. Before submitting Form 8886, Mr. McNeill called EY to inquire as to who should be included on the form as persons who promoted, solicited, recommended participation, or provided tax advice related to the transaction. Mr. McNeill wanted to be conservative and include all possible persons to ensure compliance. But the Form 8886 petitioners submitted lists only BDO and De Castro—not EY. This omission shows that even under Mr. McNeill’s conservative view, petitioners did not believe EY had promoted, solicited, recommended participation, or provided tax advice for the 2003 DAD transaction.
I should mention here that Reilly’s Fourteenth Law of Tax Planning – If something is a listed transaction, just don’t do it – had not yet been formulated.
De Castro
Value billing is what did in the De Castro opinion.
While De Castro appeared to charge a flat fee for the tax opinions, there was a prearranged fee schedule with BDO. Instead of charging a fee based on the type or amount of work to be performed, De Castro charged DAD transaction investors a fee based on the amount of tax saved—0.5% of the expected recognized loss. 22 Thus, De Castro had a financial stake in the transaction other than its normal billing; its fee was directly related to the size of the transaction and independent of actual work performed.
The conflict of interest and lack of independence is also demonstrated by the direct correlation between referrals from BDO and the conclusion of De Castro’s opinions. De Castro wrote these opinions with the understanding that BDO would refer more work to the law firm if the opinions were favorable to BDO’s clients. This close relationship shows that De Castro had an inherent [*33] conflict of interest; De Castro had a financial incentive to give favorable opinions to BDO referrals.
According to the Tax Court, Mr. McNeill should have realized De Castro was not independent since they were referred by “the promoter”. What troubles me about the Tax Court opinion is that “the promoter” was not some guy that took up investment advising because he wasn’t smart enough to get into Annapolis. The promoter was one of the top accounting firms in the country.
Tax Court Bottom Line
If Mr. McNeill’s business prowess did not allow him to make such a determination, then certainly the fact that the De Castro and BDO opinions were virtually identical in all material respects should have prompted inquiry from an independent adviser. Close inspection of the two opinions reveals that several sections were nearly verbatim. Mr. McNeill decided not to rely on the BDO opinion because he did not consider it to be an independent opinion. Because the substantive portions of the De Castro opinion and BDO’s opinion were nearly verbatim, he should have known that if he could not rely on the BDO opinion, he also could not reasonably rely on the De Castro opinion. The Court concludes that after comparison of the BDO and De Castro opinions, any reliance which Mr. McNeill placed on the De Castro opinion was not reasonable.
So it looks like the McNeills will need to pay the penalty. Is that the end of the story?
District Court Saw It Differently
The McNeill’s DAD transactions covered two years 2002 and 2003. The Tax Court decision was about the 2003 penalty. When it came to 2002, the McNeill’s paid the penalty and sued for refund. And the US District Court for the District of Wyoming (Case No: 14-CV-172-F – Sorry did not find a free link) early this year, found the penalty invalid.
While perhaps sophisticated as a businessman in the direct sale of the debt, Mr. McNeill does not appear to have been sophisticated in terms of a contribution (not sale) of debt to a partnership by a foreign entity, and the acquisition of partnership interests (as opposed to the direct acquisition of debt). While unquestionably smart and accomplished in his own right, in the context of the complex DAD shelter before the Court which was specifically designed and implemented by others to exploit the tax code’s partnership provisions, Mr. McNeill is not knowledgeable or sophisticated.
The Achilles heel of many investors arguing against the penalty is that as part of the process, they must make representations that are demonstrably false. The district court noted this problem, but
It is clear these representations were not true and it is a close call as to whether Mr. McNeill knew or should have known they were false. However, the Court finds the representations to be consistent with Mr. McNeill’s reliance on Gramercy’s track record of investing in distressed debt, along with his reasonable understanding that taxpayers may lawfully arrange their affairs to keep taxes as low as possible. The fact the tax strategy turned out to be an illegal DAD shelter and could not be used to minimize taxes does not change the analysis as Mr. McNeill was told time and again that the scheme was legal. Mr. McNeill should not be penalized by way of inferring knowledge concerning sham transactions he did not know and reasonably should not have known, particularly when lawyer “code heads” and others apparently failed to discern or disclose the illegal and abusive nature of the transactions.
I’ll have to leave it to the lawyers to sort out how much this apparent contradiction means.
Rooting For The Taxpayers
On net, I am rooting for the McNeills on this one. I took a look at the Corbin & Dorice S. McNeill Foundation and noted the $25,000 donation to the USNA Foundation for support for the preservation on naval history along with other worthy causes, which makes me think they are pretty much all right people. If after hearing about DAD, they had been aware of Reilly’s Second Law Of Tax Planning – Sometime’s it’s better to just pay the taxes – they might have passed. But there was and still is an ideology that values tax minimization a bit more than it really deserves. Collusion by the most prestigious firms and weak enforcement led people like the McNeills astray.
I find this case coming on top of the Tax Court decision in the case of Keith Tucker rather odd. The Tax Court found Keith Tucker’s reliance on professionals in a Son of Boss deal reasonable. Tucker is a lawyer and a CPA and had been busy becoming a partner in KPMG and managing a national tax group while Commander McNeill was serving beneath the deep.
Other Coverage
Lew Taishoff covered the case with a post titled Off The Hook. Mr. Taishoff is kind to EY and refers to them as X.
So if you get a memo from a lawyer or accountant with the words “realistic possibility of success” therein, ask them to keep the ripcord as a souvenir. And don’t get on that plane.
He takes a potshot at Mr. McNeill, which on close analysis is unjustified.
Before you weep for Corb and Dori, note that Corb was chairman and co-CEO of Exelon, another dodger. See my blogpost “1031 and All That,” 9/19/16.
I also covered the Exelon 1031 decison which did not exactly shed much glory on the rest of the Big 4 as it implicated Deloitte and PWC in a pretty sketchy deal. The 1031 deal, however, was done in 1999 by Unicom, before the merger that created Exelon and Mr. McNeill had been with PECO, the other side of the merger. So he does not get credit for taking bad tax advice from three out of the Big 4.
On Submarine Memoirs
You can get a pretty selection of submarine memoirs here. The list leaves out what I consider the best, which strictly speaking is not a memoir. WWII skippers when they wrote their books, thanks to highly detailed logs could tell you about every torpedo they fired. Then they would do research in Japan to figure out for sure who it was they sank. Mary Lee Coe Fowler did that type of research for Full Fathom Five – A Daughter’s Search, but she produces a much more holistic account as she also reconstructs her mother’s experience and her own. Her father did not get to write the book himself because USS Cisco under Commander James Coe is, as they say, still on patrol having left Port Darwin on 19 September 1943 and been reported overdue and presumed lost on 8 February 1944.