Daily Development for Thursday, September 2, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri firstname.lastname@example.org
FEDERAL INCOME TAX; PENALTIES: Connecticut Federal District Court holds that taxpayers are not entitled to accept opinions of outside tax counsel at face value in order to rely upon “good faith reliance” defense to tax penalties, but must evaluate whether the opinion is properly based upon relevant authority and appropriate assumptions.
Long Term Capital Holdings, et al. v. United States, 2004 WL 1924931 (D.Conn. 8/27/04)
In an opinion that may have even greater consequences to the investment community than the sixty million dollar consequence to the parties, a federal district court in Connecticut has upheld the assessment of penalties for undereporting of taxes where the taxpayer had relied upon specific advice of expensive and reputable independent tax counsel in filing its return.
The taxpayer, a large, high end hedge fund with a significant record of double digit profits but a contracting investment climate, carried out an acquisition of low value/high basis assets in an exchange for interests in the taxpayer’s partnership. It obtained an independent opinion of Shearman and Sterling that the basis computation in the assets “should” be $106 million. Later it sold back the partnership interest to the original transferor for about $1 million and claimed the claimed the benefit of approximately $100 million in losses. In connection with this transaction, it obtained a preliminary opinion from King and Spalding before it filed its return, and a final opinion from that firm about nine months later, indicating that the losses “should” be recognized.
The court first collapsed the business structure that the taxpayer claimed supported its claim, finding for the government virtually up and down the line on the complicated analysis of the transactions involved. It held that the exchange and sale back transactions lacked economic substance and must be disregarded for tax purposes. Alternatively, the court said the transactions could be recast under the step transaction doctrine in a way that would disallow the deductions. It then upheld the IRS’s claimed $ 40 million in tax deficiencies, $ 4 million in deficiency interest, and $ 16 million in penalties. The amounts of penalty derived from application of the 40 percent gross valuation misstatement and 20 percent substantial understatement penalties.
Shearman & Sterling had been heavily involved in advising on the “lease stripping” transactions that gave rise to the creation of these high basis/low value assets that later were traded to the taxpayer petitioners here. Although King & Spalding represented a party in the lease-stripping transactions, the partner who drafted the opinion given to taxpayers here stated that he was unfamiliar with those deals.
The court rejected taxpayer’s argument that they satisfied the “reasonable case” defense to penalties by obtaining legal opinions.
Most important, however, the court went on to deal with another defense to the penalties, reliance on 26 U.S.C. § 6664(c)(1), which provides, "No penalty shall be imposed under this part with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion." The regulations under that section provide that "[r]eliance on professional advice[ ] or other facts . . . constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith." The court’s analysis of the meaning of the “advice of counsel” defense is critical here, and is set forth verbatim:
“Before a taxpayer may be considered to have reasonably relied in good faith on advice, two threshold requirements must be satisfied: (1) the advice must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances, including taking into account the taxpayer's purpose for entering into a transaction and for structuring a transaction in a particular manner, and is not adequate if the taxpayer fails to disclose a fact that it knows, or should know, to be relevant to the proper tax treatment of an item; and (2) the advice must not be based on unreasonable factual and legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person, including a representation or assumption the taxpayer knows, or has reason to know, is unlikely to be true, such as, an inaccurate representation or assumption as to the taxpayer's pur poses for entering into a transaction or for structuring a transaction in a particular manner.”
With respect to the King and Spalding opinion, the court in fact found that there was no reliable evidence in the record that the taxpayers received King & Spalding's advice before filing the tax returns. King and Spalding claimed that there had been conversations explaining the substance and basis for the firm’s opinions on the deduction, but the court found inadequate evidence to support the claim that the conversations actually took place. The court noted that there therefore was no basis upon which to analyze whether the advice provided prior to claiming the losses, at least with respect to the Court's economic substance holding, was based on unreasonable legal assumptions or otherwise failed to take into account pertinent facts and circumstances and the relevant law.
Having said this, however, the court then assumed that the King and Spalding opinion had been received prior to the filing of the return, and held that nevertheless it would not have provided a defense of good faith reliance.
First, it noted that the King & Spalding opinion stated that it was prepared as part of taxpayer’s litigation strategy in anticipation of possible future litigation over the claimed losses, language sounding like a predicate for assertion of an attorney work product privilege against disclosure, which a partner in the firm testified was its purpose. The opinion's timing and stated purpose casts doubt on its contents as serving the purpose of providing a reasoned opinion on the application of tax law to the facts of the transaction for client guidance in future actions.
Fair enough (maybe), but the more important analysis was that concluding that even if the opinion had not been drafted under these circumstances, it would not have provided support because the taxpayers had failed to evaluate whether the opinion was based upon a reasonable analysis of law or appropriate assumptions of fact. Again, the precise language is important:
“[T]the advice received from King & Spalding amounted to general superficial pronouncements asking the Court to "trust us; we looked into all pertinent facts; we were involved; we researched all applicable authorities; we made no unreasonable assumptions; the taxpayers gave us all information." The Court's role as fact finder is more searching and with specifics, analysis, and explanations in such short supply, the King & Spalding effort is insufficient to carry taxpayer’s burden to demonstrate that the legal advice satisfies the threshold requirements of reasonable good faith reliance on advice of counsel.
There was other evidence in the record suggesting the absence of reasonable good faith reliance on legal advice. [The in-house counsel] discussed the King & Spalding advice with other partners only to the extent of informing them that King & Spalding would render a "should" level opinion. There was no evidence that any partners other than [one] has ever read the King & Spalding opinion, only that the principals specifically discussed that "should" level opinions would provide penalty protection.”
The court also asserted that there was evidence that the taxpayers had “dressed up” their return to disguise the true nature of what they were reporting.
Comment 1: Tax Analyst Consultants, in reporting on the case, quoted a Chicago tax lawyer as saying that the “reasonable reliance” aspect of the case had sweeping implications. The lawyer said that unless the reasonable reliance aspect of the case is reversed on appeal, he is concerned about the case's implications for professionals and clients.
“‘The court's suggestion that a client, having hired an expert, has to take the expert's opinion, read all the cases cited, and analyze whether the expert is correct in the legal analysis, sets a standard that may be difficult for people to meet in the real world, [the lawyer said]’ ‘Most clients will read an opinion to make sure the facts are correct and to understand the legal arguments. . . But to think that a client would research the legal authorities and second guess the analysis "begs the question of why hire an expert in first place?"’
Comment 2: So now we have the basic question: “Why hire an expert in the first place?” Here, the purpose, as portrayed by the government, was to get back up to defend against a penalty claim when this apparently outrageous $100 million deduction was identified and audited. Should that matter?
Can we differentiate the case where the opinion is in support of the legitimacy of the deduction, as opposed to the simple satisfaction of a technical defense? If we accept the premise, though, how do we make the differentiation?
In its opinion here, the court noted that there were a number of Second Circuit opinions in support of the government’s position that King and Spalding neglected to cite or discuss. Further, the court claimed that King and Spalding’s assumptions about the legitimacy of the business structures involved were not well founded - that everyone in the deal should have known that these structures were shams designed solely for tax avoidance, and that therefore no one in good faith should have relied upon a legal opinion based upon them. This would suggest, of course, that the opinion was “result oriented” and not designed to advise a client as to the legitimacy of the deduction itself. (The editor accepts the court’s characterization of the opinion and its analysis for purposes of discussion.)
But is it really rationale to expect individual taxpayers to be able to appreciate the subtlety of analysis without hiring other lawyers to do it? And, if so, if they can’t trust the first lawyers, why should the trust the second? I’m a lawyer, and if I got an opinion from reputable counsel that didn’t discuss Second Circuit authority in a Second Circuit case, I think I’d probably assume that there was no such relevant authority. Further, I’d trust counsel not to assume away the problem by attenuated assumptions about the appropriateness of legal structures that counsel in fact deemed to be inappropriate.
If this opinion really means what it says, then legal opinions (at least those of outside counsel) mean nothing, which of course would result in a real marketing problem for a lot of specialized law firms in New York. The fallout in terms of associate unemployment and a drop in consumer confidence at Saks, Barney’s and Bergdorfs could affect the outcome of the election.
Editor’s Comment 3: Note that the Sherman and Sterling opinion just dropped out of sight in the discussion of the penalty. Perhaps the only relevance was that the $500,000 that the taxpayer paid for that opinion gutted any hope of profit on the initial exchange, thus rendering it more likely to be found a “sham.”
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