(C) Tax Analysts 2004. All rights reserved. does not claim copyright in any public domain or third party content. edited by Robert J. Wells and Jon Almeras The Element of Willfulness: Criminal Investigation of KPMG’s Tax Shelter Operations A Defense for Tax Shelters? KPMG is being investigated by the U.S. Attorney’s Office in the Southern District of New York for some of its By David B. Porter tax strategies. The investigation focuses on specific tax strategies (the IRS calls them shelters; KPMG calls them David B. Porter is an attorney with Robert W. ‘‘solutions’’ or ‘‘tax products’’) known as the bond linked Wood, PC (http://www.rwwpc.com) in San Fran- issue premium structure (BLIPS) strategy, the foreign cisco. His practice focuses on civil and criminal tax leveraged investment program (FLIP), the offshore port- controversies and litigation. He can be reached at folio investment strategy (OPIS), and possibly the S [email protected]. The views expressed herein are corporation charitable contribution strategy (SC2). solely those of the author and should not be attributed BLIPS to any other source. KPMG pitched BLIPS as a tax-advantaged investment that would generate a large tax loss. The investor was People are always asking me for free legal advice after told that in exchange for payments to KPMG, which were finding out that I defend people in civil and criminal tax frequently in the millions, he would generate a tax loss of controversies. One of my most recent interrogations was as much as 10 to 20 times the investment. conducted by an accountant at a highbrow cocktail party. Now I don’t mind having a casual conversation about Three tax shelters — FLIP, OPIS, and BLIPS — are tax, but I try and steer clear of doling out legal advice to similar and function as ‘‘loss generators,’’ meaning they people who are already half in the bag and who are only generate large paper losses that the purchaser of the going to remember half of what I tell them anyway. (By product then uses to offset other income, thereby shelter- the way, I hear that a lawyer can be sued for giving out ing it from taxation. All three products have generated bad legal advice even when it’s at a cocktail party. hundreds of millions of dollars in paper losses for Therefore, when a prospective client is smashed, doesn’t taxpayers by using a series of complex orchestrated remember to provide all of the facts, and may only hear transactions involving shell corporations, structured fi- half of the answer, there is a greatly enhanced risk of a nance, purported multimillion dollar loans, and deliber- malpractice action.) ately obscure investments. The BLIPS transactions required a bank to lend, on a One of the topics of our conversation involved tax nonrecourse basis, money to a shell corporation with few shelters. In the process, I remarked, ‘‘You know, igno- assets and no ongoing business. The so-called loan pro- rance is a good excuse for the law.’’ To which the ceeds were instead deemed ‘‘collateral’’ for the ‘‘loan’’ accountant responded, ‘‘I thought ignorance is no excuse itself under an ‘‘overcollateralization’’ provision that for the law.’’ We proceeded to discuss the interesting required the ‘‘borrower’’ to place 101 percent of the loan concept of how the government is trying to attack proceeds on deposit with the bank. The loan proceeds, established tax shelter designers despite the fact that serving as cash collateral, were then subject to severe ignorance and complexity are both legally acceptable investment restrictions and were closely monitored by excuses for tax crimes. In doing so, we concluded that the the bank. government will have a heavy burden in attempting to prove the element of willfulness, which is one of the The end result was that only a small portion of the elements of a tax crime. funds in each BLIPS transaction was ever placed at risk in legitimate investments. Also, the banks were empowered The IRS believes that some individuals and businesses to unilaterally terminate a BLIPS loan under a variety of have promoted certain tax shelters and encouraged indi- circumstances, including, for example, if the cash collat- viduals to participate in them as a way to avoid reporting eral fell below 101 percent. The banks and investment large capital gains from unrelated transactions (talk advisory firms knew that the BLIPS loan structure and about a party gone out of control). Any person, warns the investment restrictions made little economic sense apart IRS, who willfully conceals the amount of capital gains from the client’s tax objectives, which consisted primarily and losses in that way, or who willfully advises others of generating huge paper losses for KPMG’s clients who regarding that type of concealment, may be guilty of then used those losses to offset other income and shelter criminal offenses. it from taxation. However, if the government is going to have a fighting chance at landing any indictments involving criminal BOSS offenses by a promoter, it’s going to have to figure out Another tax shelter that was widely marketed was how to circumvent the case law that developed the called the bond and option sales strategy (BOSS). The IRS definition of willfulness. shut it down with Notice 99-59, 1999-52 IRB 761, Doc TAX NOTES, September 13, 2004 1225 TAX PRACTICE AND ACCOUNTING NEWS 1999-38713, 1999 TNT 237-1. The BOSS shelter involved Willfulness: The Case Law an arrangement that applied the rules for corporate The general rule that ignorance of the law or a mistake (C) Tax Analysts 2004. All rights reserved. does not claim copyright in any public domain or third party content. distributions of encumbered property to create artificially of law is no defense to criminal prosecution is deeply high basis in the corporate stock that would produce rooted in the American legal system. See, for example, deductible losses on the later disposition of the stock by United States v. Smith, 18 U.S. 153 (1820); Reynolds v. shareholders. There are now civil cases docketed in Tax United States, 98 U.S. 145 (1879). Based on the notion that Court involving the next evolution of that strategy, the the law is definite and knowable, under common law it son-of-BOSS shelters. was presumed that every person knew the law. In Notice 2000-44, 2000-36 IRB 255, Doc 2000-21236, However, the proliferation of statutes and regulations 2000 TNT 157-7, the IRS identified arrangements involv- has sometimes made it difficult for the average citizen to ing partnership interests that created artificially high know and comprehend the extent of the duties and basis in partnership interests, resulting in deductible obligations imposed by the law, especially the tax law. losses on the later disposition of the partnership interests Therefore, Congress has softened the effect of the by the partners. In one version of the partnership varia- common-law presumption by making specific intent to tion of the shelter, a taxpayer borrowed at a premium and violate the law an element of some federal criminal tax contributed the cash to a partnership, and the partner- offenses. As a result, more than half a century ago the ship assumed liability for the debt. For example, the Supreme Court interpreted the term ‘‘willfully’’ as used taxpayer received $3,000 in cash under a loan agreement in federal criminal tax statutes as carving out an excep- that provided an inflated stated rate of interest and a tion to the traditional rule. stated principal of only $2,000. The taxpayer contributed The special treatment of criminal tax offenses is largely the $3,000 to a partnership and the partnership assumed due to the complexity of the tax laws. In United States v. the debt. The taxpayer then sold the partnership interest. Murdock, 290 U.S. 389 (1933), the Court stated, ‘‘Congress The partner took the position under sections 705(a)(2), did not intend that a person, by reason of a bona fide 722, and 752(b) that its basis in its partnership interest misunderstanding as to his liability for the tax, as to his was $1,000. The partner argued that the amount of the duty to make a return, or as to the adequacy of the liability that the partnership had assumed under section records he maintained, should become a criminal by his 752(b) was $2,000, so that under section 705(a)(2), its basis mere failure to measure up to the prescribed standard of in the partnership interest should be reduced to $1,000. conduct.’’ Id. at 396. The partner then sold the partnership interest for a The Court held in Murdock that the defendant was nominal amount and claimed a $1,000 capital loss. entitled to a jury instruction as to whether he acted in In another version, offsetting assets and liabilities good faith based on his actual knowledge. The Court were present but the taxpayer took the position that the further interpreted the term ‘‘willfully’’ generally to partnership had not assumed any liability. The taxpayer mean ‘‘an act done with a bad purpose’’ or with ‘‘an evil purchased a call option and simultaneously wrote an motive.’’ Id. at 394-95. offsetting call option. The taxpayer then contributed both Subsequent decisions have refined that proposition. In options to a partnership. The partner took the position United States v. Bishop, 412 U.S. 346 (1973), the Court that its basis in the partnership interest was the same as described the term ‘‘willfully’’ as connoting ‘‘a voluntary, its positive basis in the purchased call option, unreduced intentional violation of a known legal duty.’’ Id.