Originally published on Forbes.com.
KPMG’s woes from its tax shelter shenanigans around the turn of the millennium seem never-ending. The original story of X-Rated tax shelters being promoted by national accounting firms was broken by Janet Novack in 1999. Tanina Ross and Milton gave the topic book-length treatment in Confidence Games – Lawyers, Accountants, and the Tax Shelter Industry. That was over three years ago. Also three years ago, KPMG might have thought it was out from under a client lawsuit, but a third circuit decision in DDRA Capital Inc and John Baldwin V KPMG earlier this month indicates that the nightmare will continue.
A Racetrack, Slot Machines, And The Need For Shelter
John Baldwin helped Shawn Scott, DDRA Capital’s president, and sole shareholder purchase and finance Delta Downs Racetrack in Louisiana in 1999. DDRA sought a local referendum authorizing slot machines. The track was sold in 2001 with a profit of approximately $74 million. Baldwin got a $10 million fee and stiff interest on a $17 million loan. As Baldwin admitted in depositions, he does things for tax planning. That is why, for example, he moved to the Virgin Islands. So he and Scott looked for their best bet to shelter their big racetrack score. They picked the wrong horse – KPMG’s Short Option Strategy presented to them by Carl Hasting. Hasting would later be indicted for his role in the tax shelter madness but would get off when the federal prosecutors pressured KPMG to cut off paying his legal fees.
Credit Out The Window
The Third Circuit gave a pretty good description of SOS.
SOS involved the purchase and sale of largely offsetting options on foreign currency so as to put at risk only the net premium paid to secure the options. (DDRA, for example, spent only $613,000 when it bought “long” options on Brazilian and Mexican currency for $49,238,000 and sold offsetting “short” options on the same currency for $48,625,000.2 ) Both the long and short options were then transferred to a partnership and, in purported reliance on an old Tax Court opinion, the taxpayer’s basis in the partnership was calculated based solely on the value of the long options. See, e.g., Sala v. United States , 613 F.3d 1249, 1250-51 & n.2 (10th Cir. 2010). DDRA’s basis in the partnership, accordingly, was considered to be $49,238,000 rather than the actual net loss of $613,000 it had thus far accrued. Finally, all options would be disposed of for an amount near the actual net cost of the offsetting options, thus leaving the taxpayer claiming a tax loss in the vicinity of the value of the long options—in DDRA’s case, about $48 million, “even though the taxpayer ha incurred no corresponding economic loss.” I.R.S. Notice 2000-44.
Since the overall plan is essentially based on an unbalanced entry I call it “Debit by the window. Credit out the window”. The general approach, though, has been to disallow these things, not because of the bad accounting, but because ” a loss is allowable as a deduction for federal income tax purposes only if it is bona fide and reflects actual economic consequences”. DDRA’s $48 million loss on its 2001 return and Baldwin’s $22 million loss did not jump through the very first of the five hoops that you must make it through to post a negative number on your tax return.
It Did Not Go Well
The shelter of course totally fell apart. Baldwin was tagged with $8,554,685 in additional tax and over two million in interest and penalties. DDRA was hit with $17,121,602 in additional tax and over five million in penalties and interest. It appears that DDRA Capital did not actually pay most of the deficiency. On the final financial statement of its bankruptcy in 2006, there is a liability for over $20 million in taxes, penalties, and interest. My poking around about Shawn Scott and DDRA makes me think there might be an even more interesting story buried in here, but I stick with the tax stuff.
The Lawsuit
Mr. Baldwin and DDRA Capital filed a lawsuit against KPMG in the District Court of the Virgin Islands (St. Croix Division) on December 7, 2004. (DDRA Capital filed for bankruptcy in the same district on November 30, 2004. Something tells me that the nearness of those two dates is not a coincidence, but I haven’t figured that out.) The suit was for fraud, negligent misrepresentation, negligence, and breach of fiduciary duty under Nevada law and a federal RICO claim.
Both sides moved for summary judgment. The plaintiff’s motion was denied in April 2014. KPMG’s motion was approved in June 2014.
Blaming The Client
As a CPA, I find KPMG’s defense of itself really troubling. Essentially they said that they knew they were bad, but the client should have figured that out. The client signed something saying that he was doing the deal to make money. So the client was bad too. He should have known better than to rely on them.
Jack Townsend, who tends to be a little unsympathetic to the taxpayers in these cases, wrote about the first motion denial in 2014.
As often happens when people suffer loss, financial or otherwise, from their own misconduct, they look for a scapegoat. Baldwin thought KPMG an easy scapegoat because it has deep pockets and KPMG had entered a deferred prosecution agreement with respect to this genre of shelter and, like a man, KPMG fessed up when it was brought to its knees. ….
Mr. Townsend focuses on the statement Mr. Baldwin had to sign that indicated that he had a profit motive independent of tax savings.
This is the key point. All of the ******** tax shelters with which I am familiar required that the taxpayer represent that he or she had a profit motive independent of the tax consequences. Yet, Baldwin admitted on deposition that this was his lie. His personal representation to KPMG was a lie. (******** is a bowdlerization of Mr. Townsend’s characterization)
Here is how Mr. Townsend characterizes the lawsuit.
The question is whether one co-conspirator is entitled to recover from another co-conspirator, particularly where the co-conspirator seeking to recover was the one who would benefit most had the crime worked. It just seems to me a bit excessive to have any sympathy from a legal or moral perspective for these taxpayers.
Claims Revived
I don’t have a lot of sympathy for the taxpayers, but I have even less for KPMG. They were, probably still are, one of the most prestigious accounting firms in the world. Finding out that a deal that they recommended had no merit at all – didn’t even make good nonsense – was probably kind of shocking. Regardless, the third circuit ruled that some of the grounds of the lawsuit deserve to be considered.
The negligence claim against KPMG was restored.
Plaintiffs contend that, but for Hasting and KPMG’s misrepresentations that the SOS transaction KPMG proposed was legal and would survive IRS scrutiny, they would have pursued other tax strategies for which they would have paid no penalties or interest, no fee to KPMG, and possibly less in taxes. Both Baldwin and Scott testified they were considering alternatives—such as § 1031 exchanges, investing in companies with net operating loss, and moving to the Virgin Islands—before Hasting introduced them to the SOS transaction. Under this theory, plaintiffs have adduced sufficient evidence to show that Hasting and KPMG could have reasonably foreseen their actions in reliance—even if not justifiable—on KPMG’s misrepresentations.
The RICO claim also had new life breathed into it by the appellate decision.
An intriguing question in my mind is whether DDRA might have a windfall if the corporation prevails against KPMG or if the government still has some hook on the original tax assessment.
An Odd Defense
My biggest takeaway from all this is that KPMG is defending itself by indicating that their client should not have relied on them.
There can be no dispute that plaintiffs would have discovered the falsity of KPMG’s representations had they properly investigated. (Plaintiffs’ expert opined that a tax preparer with only a “fundamental level of competence would understand that … he cannot deduct fictional losses.”) Instead, they contend that Hasting sufficiently assured them, on the strength of KPMG’s reputation and experience, that the tax strategy was legal. But even viewing the evidence in the light most favorable to the plaintiffs, we think no reasonable juror could find that the investigation they performed in response to the red flag was sufficient.
That is a great argument for the IRS to use in asserting penalties against the taxpayers, but it rings awfully hollow when raised by KPMG to defend itself.