Originally published on Forbes.com Dec 26th, 2013
Scott Blum, founder of Buy.com, got some bad news from the Tenth Circuit last week. The Tax Court’s 2012 decision sustaining penalties of over $10,000,000 for his 1998 and 1999 income tax returns was affirmed. The Tenth Circuit was unconcerned that the Tax Court decision might allow KPMG to weasel out of civil liability to Blum for putting him into an OPIS transaction (Offshore Portfolio Investment Strategy). There is some interesting stuff in the case and we will get to that. As is often the case with tax decisions, the story behind the story is even more interesting. I somehow missed the story of Scott Blum and the miracle of Buy.com when it was happening, in the late nineties, but it is a great one.
The New Economy
Do you remember the New Economy? If not, that would be because, in retrospect, we call it the dot-com bubble. It was a real relief to me when it was over. The nascent Elderly Curmudgeon Division of CCR LLP was very troubled by the New Economy. Apparently profitability, tangible net worth, and even cash flow had entirely lost their relevance. I would not even have attempted to explain it to my first managing partner, Herb Cohan, who had boiled all business decisions down to two simple principles. -Money coming in is good. Money going out is bad- Herb’s one inevitable instruction when he saw you on your way out with your audit bag was “Bring back a check”.
At any rate, a variation on one of my favorite jokes was emblematic of the New Economy. Two brothers come into some money and decide to start a business. They buy a truck and go out to the country and buy apples from farmers for a nickel each and then sell them in the city for four cents. After about a month they run out of money and put their heads together to figure out what went wrong. The older brother says “I told you we should have bought a bigger truck”. The younger brother replies “That’s old economy thinking. What we need is a presence on the web.”
I found that joke so amusing and then I just read last night that the business plan of Buy.com was actually based on selling goods at less than cost. There was a little more to the plan than losing money on each transaction but making it up on volume, but whatever else was supposed to make it work did not come to fruition while the company was public.
Apparently, Mr. Blum founded the company in 1997, sold it in 1999 for $195 million, and bought it back in 2001 for $23.6 million. (Based on the Tax Court decision he must have sold a piece in 1998). My only regret is that the shade of Charles Mackay could not be summoned to add another chapter to Extraordinary Popular Delusions And The Madness Of Crowds right after The Mississippi Scheme, The South-Sea Bubble, and Tulipomania.
Taxation In The New Economy
New Economy companies, themselves, provided a limited scope for tax planning, since, being unprofitable and all, there is not much in the way of current corporate tax to worry about. The titans of the New Economy were getting the bulk of their income as capital gains. In the late seventies, if somebody had been paying tax on almost all their income at 20%, they would have thought that was nirvana, but all those tax minds displaced by the Tax Reform Act of 1986 had to do something. So they came up with brilliant schemes to drive the 20% down to 0%.
There was another factor driving this. Accounting is considered by some to be a high-stress job. This article puts it just a couple of notches below combat soldier. Are they serious?
After attending way too many seminars and retreats about how to unleash my potential as a salesperson, and agonizing about how unprofitable we were, I concluded that the thing that really makes accounting stressful is envy. Unless you have some sort of odd specialty, it is in the nature of the work that many of your clients will make a lot more money than you.
If you are at or near the top of your particular sector, one of your primary jobs is to hang around with likely clients or their minions and ingratiate yourself with them. We had one consultant explain to us that we should always fly first class because we were more likely to encounter prospects there. He also told us that a partner should drive at least a Mercedes – unless he is eccentric. It really seemed to me that the profession had embraced Rule 97 of the Ferengi Rules of Acquistion – “Enough is never enough”.
The desperate circumstances of CPA partners doomed to struggle along on incomes in the low to mid-six figures was created by the hard rule of selling professional services. You have to do some actual work yourself or pay somebody else to do some actual work. Although if you lack certain mental abilities, doing accounting work is virtually impossible, it is otherwise not that difficult. Certainly not if you compare it to roofing or service in the infantry. At any rate, the requirement of workplaces a limit on the amount of money that can be made.
Among the solutions to the problem was the introduction of “efficient auditing”, which as far as I could tell was making a science of how little you could do and still issue an opinion. There there is India, where in the dreams of managing partners there is an infinite supply of accounting talent ready to work for nearly nothing. Most beloved of all, though, is “value billing”. You come up with a dynamite idea and rather than sell it the nth time based on the marked-up cost of implementing it the nth time, you sell it based on “value”. In the case of the shaky shelters dreamed up in the backrooms of the Big Four in the nineties that would be a percentage of the tax avoided.
That is the background of KPMG approaching Mr. Blum and charging him $687,500 to shelter $45,000,000 in capital gains with their OPIS transaction. I make that fee to be over 7% of the tax avoided. I’m sure that KPMG had to do some work in order to implement OPIS for Mr. Blum. I don’t know exactly what was involved, so there may well have been scores, nay, hundreds of hours, involved. It seems unlikely that it was anywhere near the 2,000 to 3,000 hours that they would have needed to incur to earn $687,500 the old fashioned way.
The Achilles Heel Of The Nineties Shelters
Jack Townsend has a really good analysis of this case on his federal tax crimes blog. Unfortunately, I can’t share the title with you out of concern for the contributor guidelines. It includes a reference to bovine excrement. Sometimes in reading these cases I experience the same frustration I would have when reading softcore pornography when I was thirteen. I want to read about the actual perversions of double-entry that the Big Four hacks dreamed up to give these deals something approaching credence. The court does not always need to discuss them since they get blown up by the fact that there was no business purpose behind the transactions. That was pretty much the case with Mr. Blum’s OPIS deal as the Tenth Circuit wrote
The intricacies of this offshore financial transaction and the fog of plausible deniability surrounding it cannot make up for the clarity of the big picture: this was a transaction designed to produce nothing more than tax advantages, and the Tax Court was right to uphold the Commissioner’s actions.
The weakness in the whole structure is the representation letter that KPMG required Mr. Blum to sign in order for them to bless the deal, as explained in the Tax Court decision.
KPMG agreed to finalize and issue its tax opinion after receiving the signed representation letter. Mr. Blum signed the representation letter in May 1999. In that letter, Mr. Blum represented that he had independently reviewed the economics underlying the investment strategy and believed it had a reasonable opportunity to earn a reasonable pre-tax profit. He made this representation even though he had not performed an economic analysis of the transaction or consulted with his investment advisers about the transaction.
Mr. Blum was required to represent that he was entering into the deal because of its economic potential. Having adopted that story, Mr. Blum stuck to it in Tax Court. Neither the Tax Court nor the Tenth Circuit believed him.
Catch-22
The basic economics of these transactions was that you were buying a loss for cents on the dollar. There was some risk that the IRS would catch on and disallow the loss. You should not, however, be subject to penalties, since you had a “more likely than not opinion” from a prestigious accounting firm. In the event that the penalty was still assessed, there was a deep pocket to sue, KPMG in this case. There is a catch, though. KPMG, which had presented the deal to Mr. Blum, required him to tell them that he liked the economics of the deal. The Tax Court had ruled that Mr. Blum’s reliance on KPMG was unreasonable. Now KPMG gets to argue that since the Tax Court says he did not reasonably rely on them, KPMG can use that against him in his lawsuit against them.
KPMG argued that the tax court’s ruling against Blum on a factual issue central to his suit against KPMG — his reliance on its advice — required dismissal of the current lawsuit.
That one has my head spinning. It’s some catch, that Catch-22.
Root Of The Problem
I still think the root of the problem is that CPAs became resentful that, in our business, you have to actually do some work or at least pay some other people to do some work in order to make a living. It is clean work with no heavy lifting. The low priced life insurance available to members of the AICPA is evidence that the work is not dangerous. Nonetheless, it is work.
Further, it is a good living, but it is nowhere near as good a living as that of the people that the industry’s rainmakers have to associate with in order to make rain. Hence the search for the golden goose that could spit out money without anybody doing much work beyond the rainmaker’s arduous tasks of sipping single malt scotch and playing golf. As it turns out, the goose’s output was more like that of real geese.
You can follow me on twitter @peterreillycpa.