DC Circuit rejects partnership’s reasonable cause defense in Son-of-BOSS shelter

Palm Canyon X Investments, LLC v. Comm., (CA DC 2/16/2018) 121 AFTR 2d ¶ 2018-475

The Court of Appeals for the District of Columbia, affirming the Tax Court, has found that the Tax Court properly concluded that the totality of relevant facts and circumstances foreclosed a reasonable-cause defense to the gross valuation misstatement penalty under Code Sec. 6662(h). The taxpayer’s decision to proceed with a Son-of-BOSS transaction in the face of IRS’s express warning against such schemes—and in reliance only on advice provided by the tax shelter’s promoters and their affiliates, other skeptical advisors, and ill-informed tax opinions—was neither reasonable nor taken in good faith.

Background. Taxpayers are subject to a 20% accuracy-related penalty for an underpayment of tax required to be shown on a return that is attributable to a substantial valuation misstatement. (Code Sec. 6662(a), Code Sec. 6662(b)(3)) The penalty is 40% of the portion of an underpayment of tax attributable to one or more substantial valuation misstatements that meet the requirements for a gross valuation misstatement. (Code Sec. 6662(h)) A gross valuation misstatement exists if the value or adjusted basis of any property claimed on a tax return is 200% (400% under a prior version of this provision that was applicable to this taxpayer’s case) or more of the amount determined to be the correct amount of such value or adjusted basis. (Code Sec. 6662(h)(2)(A))

Under Code Sec. 6664(c)(1), an accuracy-related penalty under Code Sec. 6662 will generally not apply to any portion of an underpayment if it is shown that there was reasonable cause for that portion and that the taxpayer acted in good faith. Reasonable cause requires that the taxpayer exercise ordinary business care and prudence as to the disputed item. (Neonatology Associates, (2000) 115 TC 43, affd (CA 3 2002) 90 AFTR 2d 2002-5442). Good faith means, among other things, an honest belief and an intent to perform all lawful obligations. (Hirschfeld, (CA 4 1992) 70 AFTR 2d 92-5697) A taxpayer’s education and business experience are relevant to the determination of whether the taxpayer acted with reasonable reliance on an adviser and in good faith. (Reg. § 1.6664-4(b)(1))

A taxpayer claiming reliance on a tax professional must prove that:

  1. The adviser was a competent professional who had sufficient expertise to justify reliance;
  2. The taxpayer provided necessary and accurate information to the adviser; and
  3. The taxpayer actually relied in good faith on the adviser’s judgment. (Neonatology)

Facts. In the ’90s, several law and accounting firms marketed to wealthy individuals tax-avoidance schemes known as Bond and Options Sales Strategy (BOSS) and, later, Son-of-BOSS tax shelters. The Son-of-BOSS tax scheme transferred a taxpayer’s assets that were, or would be, encumbered by significant liabilities to a partnership created for the purpose of generating tax benefits. That encumbrance would artificially inflate the taxpayer’s basis in its partnership interest and, upon dissolution of the partnership, would give the taxpayer a write off for the artificial partnership losses.

In September 2000, IRS issued Notice 2000-44, 2000-2 CB 255 (see Weekly Alert ¶ 3 08/17/2000), which described the Son-of-BOSS tax shelter and identified as a listed transaction the simultaneous purchase and sale of offsetting options and the subsequent transfer of the options to a partnership. In Notice 2000-44, IRS declared the sham partnership transactions that formed the basis of the Son-of-BOSS schemes to be abusive tax shelters and warned taxpayers that the use of such schemes could result in the imposition of stiff penalties.

Alan Hamel is the sole owner and shareholder of ThighMaster World Corporation. Hamel formed and was the sole owner of AH Investment Holdings, LLC, which in turn, became a partner entity in, and the tax matters partner for, Palm Canyon X Investments, LLC, the sham partnership for the Son-of-BOSS tax shelter scheme at issue here.

In August 2001—nearly a year after Notice 2000-44 condemning Son-of-BOSS tax shelters was issued—Clifton Lamb, a CPA who advised Hamel on tax matters, pitched the Son-of-BOSS tax shelter to John Ivsan of the now-defunct law firm Cantley & Sedacca, LLP. Lamb’s first reaction was that the proposed tax benefits were “too good to be true”. At Hamel’s direction, Lamb reviewed a generic tax opinion prepared by the law firm of Bryan Cave, LLP that provided support for the tax shelter.

Ken Barish, Hamel’s tax attorney, also reviewed Bryan Cave’s generic tax opinion at Hamel’s instruction. Barish repeatedly expressed skepticism about the legitimacy of the proposed tax scheme. Barish and Lamb subsequently reviewed a second tax opinion prepared by Mark Kushner, an attorney at the law firm of Pryor Cashman, to whom they were referred by Cantley & Sedacca. Barish and Lamb advised Hamel that Kushner had provided “an aggressive tax opinion”.

Nonetheless, in October 2001, Hamel decided to go forward with the transaction and engaged the promoter firm, Cantley & Sedacca, to implement the tax shelter for a $325,000 fee. Hamel then, through Cantley & Sedacca and an affiliated broker-dealer, Daniel Brooks, purported to form Palm Canyon as a partnership between AH Investment and a LLC owned by Brooks. Ultimately, IRS declared the tax shelter to be an unlawful Son-of-BOSS scheme and invalidated all of the claimed tax benefits and imposed a 40% tax penalty.

Tax Court decision. In Palm Canyon X Investments, LLC, TC Memo 2009-288, the Tax Court upheld IRS’s denial of the taxpayer’s deductions stemming from the use of a sham partnership. The Court concluded that Palm Canyon was a sham partnership; its transactions lacked economic substance; and Code Sec. 6662’s 40% gross valuation misstatement penalty properly applied to the resulting substantial underpayment of taxes. The Court also concluded that the taxpayer, Palm Canyon X Investments, lacked reasonable cause for its gross underreporting.

The only issue on appeal was whether the Tax Court properly rejected the taxpayer’s reasonable-cause defense to the tax penalty. Palm Canyon argued that Hamel reasonably relied on lawyers and tax advisors in deciding to go through with the scheme, and thus that the 40% penalty shouldn’t apply.

Appellate Court decision. The DC Circuit found no error in the Tax Court’s conclusion that the totality of relevant facts and circumstances foreclosed a reasonable-cause defense to the tax penalty.

First, the Court reasoned that a claim of objective reasonableness must overcome the fact that Notice 2000-44—which expressly warned taxpayers against the use of Son-of-BOSS tax shelters—had been a matter of public record for a year before the Palm Canyon scheme was put into motion. And importantly, Notice 2000-44 specifically identified as prohibited almost the exact Son-of-BOSS variation used by Palm Canyon.

Second, Palm Canyon’s reliance on advice given by Cantley & Sedacca, Ivsan, or Brooks was of no help. It was settled law that reliance on the professional advice of those one knows, or should know, to be promoters of a tax scheme is objectively unreasonable.

Third, Lamb’s advice provided no cover for this scheme. His role was largely limited to investigating the promoter’s bona fides, not providing tax advice. Further, he testified that, while he did not feel qualified to provide an opinion on the technical merits of the scheme, he believed the tax benefits were “too good to be true”. Reliance on professional advice was not reasonable where improbable tax advantages signal the tax shelter’s illegitimacy. In addition, Lamb performed only a cursory review of the completed return because he did not feel comfortable with the transaction.

Fourth, consultations with Barish offered no shield either. He said he was “skeptical” of the transaction, based on his prior experiences with tax shelters, and he didn’t have any substantive input as far as the tax opinion itself. Given that Barish and Lamb both recognized that the proposed partnership strategy was a tax-avoidance scheme, the Tax Court did not err in concluding that they neither conducted a proper investigation of the transaction nor provided an independent opinion concerning its legitimacy on which Palm Canyon could reasonably rely. Rather, they limited their due diligence to the scheme’s players, not its substance, and relied on the opinions of its promoters.

Fifth, the tax opinions provided by Bryan Cave and Mark Kushner did not aid Palm Canyon. Reg. § 1.6664-4(c)(1)(i) requires, among other things, that professional advice be based on “all pertinent facts and circumstances” relating to the taxpayer before reliance can be reasonable. The generic Bryan Cave opinion was not prepared for Palm Canyon and did not necessarily focus on facts peculiar to it. Indeed, the opinion itself cautioned that courts frequently disallow reliance on an opinion of counsel that was not directed to the specific investor.

The DC Circuit highlighted that Kushner’s opinion was doubly unreliable. He and his law firm were part of Cantley & Sedacca’s tax-scheme promotion team, and it was Cantley & Sedacca that pointed Lamb to Mark Kushner. In addition, the express terms of the tax opinion required the taxpayer to submit a signed representations sheet to Pryor Cashman attesting that all relevant information had been provided before reliance could be justifiably placed upon any opinion rendered. Neither Hamel nor Lamb ever submitted a signed representations sheet. Worse still, Hamel failed to provide the law firm with documents detailing necessary and fundamental aspects of the scheme that might have had a material effect on its professional assessment.

References: For the reasonable cause/good faith defense to accuracy-related penalties, see FTC 2d/FIN ¶ V-2060; United States Tax Reporter ¶ 66,644.

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