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Tax Court Rules Taxpayers Should Have Questioned Legal Advice

11 / 28 / 2017

McNeill v. IRS, T.C. Memo 2017-206 (10-18-2017)

In this Tax Court case, the court rules that even though the taxpayer sought and obtained advice from legal counsel before they invested $150,000 in a tax savings strategy involving a foreign distressed debt structuring, it was obvious that after only four months of ownership, it was unlikely that it could generate a $10 million loss for Federal tax purposes.  

Mr. McNeill, the husband taxpayer, is reported to have graduated from the Naval Academy in 1962, and served as an officer until 1981, commanding a nuclear sub at the time of his retirement.  He began to work in the nuclear power industry and then joined Philadelphia Electric Co. (PECO), eventually working his way up and becomeing PECO's CEO in 1996.  When PECO merged with Unicom Corp. (renamed Exelon Corp), he became chairman and co-CEO, with direct oversight of the CFO.  Mr. McNeill retires from Exelon in 2002, but continues to serve as a director on various boards and gets substantial benefits package which includes vested stock options valued at over $66 million.

E & Y provides financial and tax advice to Mr. and Mrs. McNeill, and project that if all of these stock options vest and are exercised in 2002 (at $50 per share), they would realize $66,486, 284 in gross income.  Mr. McNeill investigates several strategies aimed at minimizing this tax liability, and he chooses a strategy marketed by BDO Seidman, LLP, in conjunction with Gramercy Advisors--called a distressed asset/debt (DAD) transaction.  He purchases 2 of these.

He signs an agreement for consulting services late in the year, on November 25, 2002, relating to the first DAD transaction.  BDO agress to provide him with a tax opinion regarding the tax consequences.  The agreement also advised Mr. McNeill to retain a law firm for legal advice and additional legal opinions.  Mr. McNeill is obligated to "pay" BDO $1,450,00 for these DAD-related consulting services.

In the first DAD, a Gramercy entity contributed Brazilian consumer debt to an LLC that offers Mr. McNeill the opportunity to invest in another entity that owned Brazilian consumer debt with a high cost basis and low FMV.  For $3 million, Mr. McNeill then purchases a Gramercy/DAD loss, to be deducted on his 2002 tax return.  He then turns around and on December 31, 2002, contributes an additional $16,943,863 to the LLC to increase his basis in the entity.  An allocated loss is generated, at over $20 million.

Then in a second DAD, in 2003, a new Gramercy LLC entity sets up a new entity, and on May 20, 2003, Mr. McNeill purchases 89.1% of the new entity for $149,997.95, with Mr. McNeill made the sole manager and TMM of the entity.  That entity contriubtes "its" Brazilian consumer debt to another Gramercy LLC entity and a Gramercy affiliate is named the sole manager.  On July 1, 2003, Mr. McNeill contributes $2,850,00 to to the Gramercy LLC "contributing" co-member, and by year's end, in 2003, contributes additional assets worth $8,321,394 to that entity.  At that time, the entity's manager directs the entity to sell a portion of the Brazilian consumer debt to a different Gramercy affiliate, resulting in a loss, and the allocated loss of this 2003 DAD transaction to Mr. McNeill is $10,300,522.

BDO provides Mr. McNeill with the names of 2 law firms that would write legal opinions on the tax consequences of the DAD transactions.  One was based in Calf., the other in NY.  The BDO partner tells Mr. McNeill that the law firms provided other clients with favorable tax opinions on DAD transactions.  Mr. McNeill goes with the Calf firm, because it was headquartered in Calf., closer to his Wyoming home.  The BDO partner calls the Calf law firm to arrange for and set the price for the tax opinion for the 2002 DAD transaction. A prearranged fee of $100,000 was paid.  After the consumer debt was sold, the more likely than not tax opinions were generated, addressed to both Mr. McNeill and the entity that was formed over which he was the sole Tax Matters Member.  $50,000 was eventually paid for the 2003 DAD transaction legal opinion.

E&Y concluded that because of Treasury Regulations issued effective as of February 28, 2003, prior to the consulting agreements, that Mr. McNeill should file IRS Form 8886 but that EY should NOT be listed as a "material advisor" because it had not provided any tax advice with regard to the 2003 DAD transaction--even though it was a "loss transaction"-type reportable transaction on the Form 8886 and the taxpayers deducted $10,300,552 ordinary loss on the return.  Prior to filing the tax return, Mr. McNeill expressed to E&Y that he wanted to err on the side of overdisclosure, and report all persons who had recommended participation, but E&Y concluded that it did not need to be disclosed.  Therefore, only BDO and the Calf law firm were disclosed on the form 8886.

When BDO prepared the enitity Forms 1065 and subsequent K-1s, and filed its own Forms 8886, it also listed Gramercy.  Mr. McNeill notices the discrepancy between the two Forms 8886 and inquires of E&Y, and while Mr. McNeill states that E & Y agreed that Gramercy should have been added to the personal Form 8886, it appears that that change was not made.

Because the 2003 Form 1040 claimed an overpayment of income tax of $3.6 million, this was refunded.  Following FPAA issued assessments, estimated deposits were made to satisfy the jurisdictional requirements to contest the deficiency and interest flowing through because of the loss, but not to cover any penalties.

Eventually, the penalty issues flowed through, and collection proceedings began.  At a CDP hearing, on the McNeills in the 2003 tax year, the taxpayers sought to contest the underlying penalty because they did not have a prior opportunity to raise partner-level defenses to the assertion of the penalties.  The Tax Court at ruled earlier that it had jurisdiction to review IRS' determination as it related to the accuracy related penalties.

The Tax Court performed a de novo review of the IRS' determination and application of a IRC 6662 penalty for the taxpayers' involvement in a DAD transaction.  Finding that the IRS had the initial burden of production with respect to an penalty under IRC Section 7491(c), the IRS had to produce evidence regarding the appropriateness of the penalty, focused on the computations.  After doing so, the taxpayer bears the burden of proving that the penalty is inappropriate because of reasonable cause or otherwise.  Using a case-by-case approach, taking into account all pertinent facts and circumstances, including the taxpayer's knowledge and experience, the Tax Court noted that the most important factor is the taxpayer's effort to assess his proper tax liability. Regs. 1.6664-4(b)(1).

While the Tax Court then indicates that under Boyle, the taxpayer may demonstrate a reasonable cause defense to any penalty, showing good-faith reliance on the advice of an independent professional, as to an item's tax treatment, it had to be shown by a preponderance of the evidence that the taxpayer (1) reasonably believed that the professional upon whom the reliance was placed is a competent tax advisor with sufficient expertiese to justify reliance; (2) provided necessary and accurate information to the advisor; and (3) actually relied in good faith on the advisor's judgment (citing to Neonatology Assocs, PA v. IRS, 115 T.C. 43, 98-99 (2000), aff'd 299 F.3d 221 (3d Cir. 2002), Rovakat, LLC v. IRS, T.C.Memo 2011-225, aff'd, 529 F.Appx 124 (3d Cir. 2013; Regs. 1.6664-4(c)(1).

Mr. McNeill claimed that he reasonably relied in good faith on the advice of two independent professionals, E & Y and the Calf law firm, for the tax treatment of the 2003 DAD transaction.  The court disagreed.  

First, the mere fact that E & Y prepared and signed the 2003 tax return was not sufficient, even when the preparer also prepared internal memorandum, looking at the transactions for a "realistic possibility of success."  However, that standard comes from the tax return preparer penalty regulations under IRC 6694.  Plus the taxpayer Mr. McNeil did not receive these memorandums, generated internally, so he could not say that he relied upon them.  The fact that the Form 8886 did not include E & Y also demonstrates lack of reliance (i.e. that he did not believe that E&Y had recommended participation or provided tax advice for the 2003 DAD transaction).

Second, as to the Calf law firm, De Castro, and their legal opinion, the Tax Court noted that taxpayers like the McNeills cannot avoid a penalty by relying on an adviser who is not independent, because only an independent adviser is "unburdened with a conflict of interet and is not a promoter of the transaction."  As the Tax Court puts it, "taxpayers cannot reasonably rely on advice from an adviser that they knew or should have known was not independent because of an inherent conflict of interest" (i.e., because it was a promoter with a financial interest in the transaction, besides his normal billing).  The Calf law firm did charge a flat fee for the tax opinions, but it was based on a prearranged fee schedule with BDO (a fee based on the amont of tax saved--.5% of the expected recognized loss).  Because the fee was directly related to the size of the transaction and independent of the actual work performed, it was found to have created a financial state in the transaction for the Calf law firm.  The Tax Court also examined the conflict of interest and lack of independence, demonstrated by the direct correlation between referrals from BDO and the conclusion of the opinions.  The Tax Court concluded that the Calf law firm wrote "these opinions with the understanding that BDO would refer more work to the law firm if the opinions were favorable to BDO's clients" and thus "this close relationship shows that (DeCastro)(Calf law firm) had an inherent conflict of interest; (it) had a financialinterest to give favorable opinions to BDO referrals."

The Tax Court then noted that the fact that the Calf law firm was one of only 2 law firms BDO referred should have also indicated to Mr. McNeill that the Calf law firm might not be independent.  Since BDO had told Mr. McNeill that the firms had always given favorable opinions, he should have known that the law firm was not independent.  The fact that there were interactions amont the promoter the client and the law firm show that  the Calf law firm's tax opinion was essentially a product a promoter provided to investors.  BDO facilitated the hirign of the Calf law firm, and reached out to the firm to set the fee.  BDO did not offer that Mr. McNeill had the opportunity to use a law firm other than the 2.  By working with BDO, which coordinated with the Calf law firm, Mr. McNeill could not be said to have been unaware of their relationship.  Relying on a promoter, as an intermediary, to line up an "Independent" opinion is not sufficient to establish independence.  See also Rovakat, LLC v. IRS.  The disclsimers in the opinions also gave the Court pause, and which served as notice to the McNeills that the legal opinion was tenuous.   According to the Tax Court, taxpayers who "blindly rely" on a professional opinion to support a transaction that is too good to be true on its face, does so at his or her own peril.

The Court sustained the lien and levy actions taken by the IRS in collecting on the penalty.