The Latest Zpic Target: Medicare Cost Reports

(For additional information concerning ZPICs, please refer to our January 11, 2013 blog entry, “ZPICs and Skilled Nursing Facilities: Medicare’s Wild Wild West”).

A. Cost Reports, Generally

When Medicare was created in 1966, Medicare paid participating providers (e.g. hospitals and skilled nursing facilities) based on a portion of their costs. Medicare’s portion of costs was determined by multiplying total costs by the ratio of Medicare charges to all charges. Providers were paid an estimated amount on an interim basis; however, providers filed a “cost report” at the end of each year in order to compute a final settlement. Generally, the cost report aggregated a providers’ detailed financial data. If Medicare overpaid the provider from the interim payments, a payable was generated from the provider. If Medicare underpaid the provider from the interim payments, a receivable was generated to the provider. Medicare discontinued this payment system in 1983 (for hospitals) and 1998 (for nursing homes).

Medicare now utilizes a prospective-based reimbursement system which has no relation to a providers’ actual cost report. While providers are still required to file cost reports as a condition of participation in the Medicare program, the cost report no longer impacts the settlement process. Rather, the Centers for Medicare and Medicaid Services (“CMS”) utilizes the data to compute national reimbursement rates. In other words, a providers’ Medicare cost report is used by CMS for informational purposes only.

B. ZPIC Requests for Provider Business and Financial Data

As briefly referenced in our January 11, 2013 blog entry, “ZPICs and Skilled Nursing Facilities: Medicare’s Wild Wild West,” ZPIC auditors are demanding that skilled nursing facilities produce, in addition to patient/resident medical records, confidential and proprietary business and financial records. Generally, these demands include requests for the following: (a) detailed general ledgers; (b) audited financial statements; (c) organization charts; (d) journal entry descriptions; (e) chart of accounts; (f) board meeting minutes; (g) facility check register; (h) list of facility credit card holders and bills; (i) facility grouping schedule; (j) working trial balance; (k) balance sheets; (l) profit and loss statements; (m) floor plans; (n) facility and corporate policy and procedures manuals.

These requests not only appear to exceed the scope of a ZPIC’s authority, but also appear duplicative. When the ZPIC is questioned as to its authority to request such information, the ZPIC frequently responds citing generally to the Social Security Act. When pressed for specific citations to legal authority, the ZPIC may cite to 42 CFR §§420.301-304. Interestingly, 42 CFR 420.301-304 falls under Subpart D, “Access to Books, Documents, and Records of Subcontractors” (Emphasis added). A skilled nursing facility, however, does not fall under the definition of a “subcontractor” as defined in 42 CFR §420, Subpart D. Despite advising the ZPIC of this flaw, the ZPIC is generally unwilling to engage in any further discussion relative to the scope of its authority.

Further, the requested financial information is duplicative given CMS already obtained the financial data in the normal course of business via the provider’s Medicare cost reports. Of course, if CMS, c/o its Fiscal Intermediary/Medicare Administrative Contractor (“FI/MAC”), had an issue with the information contain in the provider’s cost report, the issue would have been addressed at that time. Yet, a request for a provider’s financial data from several years prior appears to be a means of harassing a provider into noncompliance following an endless barrage of detailed and dated financial document requests.

C. Are Medicare Cost Reports “Fair Game” for ZPICs? 

When a nursing home fails (or is otherwise unable) to produce such business and financial data, the ZPIC may instruct the FI/MAC to a issue “Notice of Change of Amount of Program Reimbursement” for each corresponding fiscal year end period. The result may be as severe as a reopening of each corresponding fiscal year end period and denying some or all of the provider’s Medicare costs referenced therein.

Interestingly, the regulations clearly state that the FI/MAC is the only entity with the authority to reopen provider cost reports and make determinations relative to same. See 42 C.F.R. §405.1801, et. seq. Further, while Section 4.7.1 of the Medicare Program Integrity Manual permits a ZPIC to compile and review cost reports, the ZPIC Zone 7 Statement of Workexpressly excludes cost report action from the scope of a ZPIC’s authority (e.g. reopening and denials).

However, the FI/MAC typically accepts the ZPICs directives without question or analysis. More importantly, the FI/MAC generally has no knowledge concerning the underlying basis for the ZPIC’s cost report action. In other words, the ZPIC and FI/MAC make it clear that the ZPIC is the sole entity making all decisions and determination relative to the providers cost reports. Thus, the FI/MAC is simply issuing correspondence based on ZPIC directives.

D. A Lack of Provider Business and Financial Data Cannot be the Basis of a ZPIC’s Adverse Cost Report Determination

ZPICs have asserted, in no uncertain terms, that the failure (or inability) to produceall of the demanded financial documentation will lead to the reopening and denial of all Medicare costs contained in the corresponding fiscal year end cost reports.

However, a provider’s failure (or inability) to produce all of the demanded financial and business records has no relation to the actual ZPIC cost report determinations. In addition to aggregating a provider’s financial data (for informational purposes only), a Medicare cost report also includes RUG scores (a/k/a the rate CMS will pay the provider for a given resident). These RUG scores are multiplied by a skilled nursing facility’s census to identify Medicare days paid. Despite requesting business and financial data, ZPICs are reopening cost reports relative to Medicare days paid and making their determinations accordingly. The ZPICs’ conduct is the equivalent of stating that no skilled nursing facility resident during the same periods qualified for Medicare and any payments received by the skilled nursing facility for those Medicare residents must be returned. Yet, whether a resident qualified for Medicare and whether that information was accurately included in the provider’s cost report has no relation to, for instance, a provider’s failure or inability to produce unrelated credit card statements and/or building floor plans. Instead, a determination relative to the accuracy of a provider’s resident Medicare costs would require an analysis of the actual facility residents during the corresponding periods. Even still (and as previously noted), a provider’s Medicare cost reports are merely informational.

E. Does a Provider Have Appeal Rights?

While providers are given the opportunity to appeal cost report reopenings/denials (whether before the Provider Reimbursement Review Board or the MAC, depending upon the amount at issue), appeals may be futile given regulations which permit CMS, c/o the U.S. Department of the Treasury, to begin recouping and/or offsetting Federal and certain eligible state funds due the provider. In essence, the provider is at risk of being choked out of business with millions of dollars earmarked by the ZPIC for recoupment/offset before the provider can assert its appeal rights, even in an action arguably void at its inception. Whether a provider should exercise its appellate rights or seek some other type of relief from a cost report reopening/denial is ultimately a fact-intensive analysis which should be made in light of all of the circumstances affecting the provider’s business.

Fuerst Ittleman David & Joseph, PL will continue to monitor the ZPIC landscape. For more information concerning the foregoing, please contact our firm’s litigation department by calling 305.350.5690, or by emailing us at contact@fidjlaw.com.

Queen Shoals Ponzi Scheme Defendant Pleads Guilty

A United States District Court Judge for the Western District of North Carolina sentenced Gary D. Martin, of St. Augustine, Florida, to a 10-year prison sentence for his participation in a 30 million dollar commodities and foreign exchange Ponzi scheme. As reported, Martin pled guilty in February 2012 to one count of money laundering conspiracy, and was sentenced this week to the statutory maximum 10-year prison term. Along with his prison sentence, he was also ordered to pay $28.5 million in restitution to scheme victims.

According to court documents, Martin, through Queen Shoals Consultants, LLC and the Queen Shoals web site and other means, also made false claims about Queen Shoal’s financial expertise in “Self-Directed IRA Strategies and Fixed Rate Accounts.” Martin held Queen Shoals out as “leaders in Professional Private Placement Retirement Planning” and falsely claimed that Queen Shoals had a “proven method of diversification [that] spreads the risk nicely for a balanced portfolio,” when, in fact, Queen Shoals offered no such diversification and funneled victim funds solely into the scheme.

Martin and his wife, Brenda, acted as so-called “consultants” who, after forming Queen Shoals Consultants, LLC solicited potential investors by telling them that Queen Shoals Consultants had over 20 years of experience in financial services, and that Martin had vast experience dealing with commodities and foreign currencies. Investors were promised annual returns ranging from eight to twenty-four percent, along with an additional 1% to investors who rolled over their IRA balances.

Through Queen Shoals Consultants, the Martins raised over $20 million from investors through in-person solicitations, written materials, and a website. All funds raised by the Martins were then turned over to Sidney Hanson (the operator of the Ponzi scheme), who paid the Martins at least $1.44 million in undisclosed referral fees.

However, Queen Shoals was far from a legitimate operation. Instead, Hanson masterminded an elaborate Ponzi scheme that incurred massive losses in the minimal forex trading that actually did occur. The remainder of the funds taken in from investors were used to pay quarterly interest payments to existing investors, referral fees to so-called “consultants”, and to sustain Hanson’s lavish lifestyle.

Martin and his wife previously agreed to settle (see here and here) an action brought by the U.S. Commodity Futures Trading Commission by agreeing to permanent bans from the commodities trading industry, as well as agreeing to make full restitution to defrauded investors. Completing the pile-on, the SEC also brought an action, see here.

Between Hanson and the Martins, over $9 million has been paid into the Court registry for eventual distribution to victims.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience litigating against the federal government in both civil and criminal matters involving highly regulated industries. You can reach at attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.

US Court Orders Wegelin to Pay a Total Penalty of $74 Million

As has been widely reported, the United States District Court for the Southern District of New York sentenced Wegelin & Co, the oldest Swiss private bank, to pay an additional $58 million after it admitted to helping wealthy Americans evade taxes. The press release issued by the U.S. Attorney’s Office for the Southern District of New York is available here. Our prior report on the Wegelin indictment is available here and our prior report on the Wegelin guilty plea is available here.

As noted in the press release

Together with the April 2012 forfeiture of more than $16.2 million from WEGELIN’s U.S. correspondent bank account, this amounts to a total recovery to the United States of approximately $74 million. WEGELIN pled guilty in January 2013 to one count of conspiracy to defraud the IRS, file false federal income tax returns, and evade federal income taxes before U.S. District Judge Jed S. Rakoff, who also imposed today’s sentence. This case represents the first time that a foreign bank has been indicted for facilitating tax evasion by U.S. taxpayers and the first guilty plea and sentencing of such a bank.

Manhattan U.S. Attorney Preet Bharara said: “Wegelin has now paid a steep price for aiding and abetting tax fraud that should be heeded by other banks, bankers, and advisers who engage in the same conduct. U.S. taxpayers with undeclared accounts – wherever those accounts may be – should know that their bank may be next, and they should pay what they owe the IRS before we come find them.”

Wegelin, which had $25 billion in assets at the end of 2010, said at the time of its guilty plea in January said it would close.

Reuters described the March 4 hearing as follows:

During Monday’s hearing, [District Court Judge] Rakoff followed prosecutors’ recommendations and imposed a $22.05 million fine and ordered $20 million in restitution. He also entered an order finalizing $15.82 million in forfeitures, which he preliminarily approved at the time of the guilty plea.

But while Rakoff approved the plea deal, he said there was a “funny tension” between the U.S. Justice Department’s decision not to seek the maximum $40 million fine and its assertion Wegelin acted with “extreme willfulness.”

Rakoff said even including the $16.3 million the government recovered in April 2012 by seizing money in Wegelin’s U.S. correspondent account, the bank will be giving up just 12 percent of the 560 million Swiss francs ($613 million) it earned after it sold most of its assets to regional Swiss bank Raiffeisen last year.

“Not much pain there, is there?” Rakoff said.

Rakoff, who has previously rejected U.S. Securities and Exchange Commission settlements with Citigroup Inc and Bank of America Corp, ultimately accepted the proposal, which prosecutor Daniel Levy called “very substantial.”

What does the prosecution mean for U.S. taxpayers? While it remains to be seen, it appears that the U.S. Government’s attempt to increase the pressure on U.S. taxpayers and foreign banks that have assisted U.S. taxpayers with skirting their reporting obligations has not slowed at all. In fact, it appears to be increasing. The result is that U.S. taxpayers who still are attempting to hide their assets out of the country to avoid U.S. taxation may be losing their window of opportunity to make amends and pay civil penalties and avoid criminal prosecutions.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in navigating the world of offshore bank accounts and the reporting requirements of U.S. taxpayers with the IRS. One can contact an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.

Senate Committee on Banking Holds Hearing on Lax Enforcement of the Bank Secrecy Act

As recently reported, the Senate Committee on Banking, Housing and Urban Affairs (information here), on March 7, 2013, held a hearing on “Patterns of Abuse: Assessing Bank Secrecy Act Compliance and Enforcement”, see here. The committee, led by Senator Tim Johnson of South Dakota, and Ranking Member Mike Crapo of Idaho, directedquestions to David S. Cohen, the U.S. Treasury Department’s Undersecretary for Terrorism and Financial Intelligence, Thomas J. Curry, Comptroller of the Comptroller of the Currency, and Jerome H. Powell, a Federal Reserve governor. Mr. Cohen’s testimony is available here, Mr. Curry’s testimony is available here, and Mr. Powell’s testimony is available here.

The Senators asked numerous questions regarding why international banks appear to be too large to prosecute and why no individuals at the large international banks have been prosecuted. Senator Mark Warner

of Virginia commented, “I do not… believe that it can be the position of the United States government that any institution should be too large to prosecute.”

With respect to HSBC, Senator Elizabeth Warren noted that “HSBC paid a fine, but no individual went to trial, no individual was banned from banking, and there was no hearing to consider shutting down HSBC’s activities here in the United States.”  HSBC avoided criminal prosecution in its deferred prosecution agreement with the Justice Department and paid a penalty of $1.92 billion.  Warren went on to state: “But evidently, if you launder nearly a billion dollars for drug cartels and violate our international sanctions, your company pays a fine and you go home and sleep in your own bed at night,” she added. “I think that’s fundamentally wrong.” (Rolling Stone’s rhetorical coverage of the HSBC case, which is representative of the coverage this story has received since being made public, is available here.)

Recently, Attorney General Eric Holder testified that some large banks are too large to prosecute, see here and here. In December, Senator Jeff Merkley was one of three Senators who wrote to Attorney General Eric Holder asking about the lax enforcement of financial institutions, specifically HSBC, and the widespread use of deferred prosecution agreements with them.  The recent activity on Capitol Hill suggests that after years of lax enforcement of international banks the U.S. Department of Justice, with overwhelming pressure from Congress, may be forced to increase scrutiny, which may result in criminal prosecutions for institutional and/or individual violations of the Bank Secrecy Act.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive civil and criminal experience litigating against the U.S. Government and defending targets of both civil and criminal investigations by the U.S. Department of Justice, the various Agencies of the U.S. Government, and the State of Florida.  You can contact an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.

Third Circuit Court of Appeals Affirms Tax Court Decision on CARDS Tax Shelter

On February 25, 2013, the United States Court of Appeals for the Third Circuit in the case of Crispin v. Commissioner, ___ F.3d ___, 2013 U.S. App. LEXIS 3852 (3d Cir. 2013), available here, affirmed the decision of the Tax Court (Crispin v. Comm’r, T.C. Memo 2012-70, available here) which held, among other things, that the CARDS tax shelter did not result in an ordinary loss deduction for the taxpayer. The Third Circuit described the CARDS transaction as follows:

A CARDS transaction is a tax-avoidance scheme that was widely marketed to wealthy individuals during the 1990’s and early 2000’s. It purports to generate, through a series of pre-arranged steps, large “paper” losses deductible from ordinary income. First, a tax-indifferent party, such as a foreign entity not subject to United States taxation, borrows foreign currency from a foreign bank (a “CARDS Loan”). Then, a United States taxpayer purchases a small amount, such as 15 percent, of the borrowed foreign currency by assuming liability for a an equal amount of the CARDS Loan. The taxpayer also agrees to be jointly liable with the foreign borrower for the remainder of the CARDS Loan and so the taxpayer purports to establish a basis equal to the entire borrowed amount.

The Commissioner contends that that step in the CARDS transaction “is predicated on an invalid application of the … basis provisions of the Internal Revenue Code.” (Appellee’s Br. at 4.) Specifically, I.R.C. § 1012 (available here) provides that a taxpayer’s basis in property is generally equal to the purchase price paid by the taxpayer. That purchase price includes the amount of the seller’s liabilities assumed by the taxpayer as part of the purchase, on the assumption that the taxpayer will eventually repay those liabilities. See Comm’r v. Tufts, 461 U.S. 300, 308-09 (1983) (available here) (noting that a loan must be recourse to the taxpayer to be included in basis). But in a CARDS transaction, the Commissioner argues, the taxpayer and the foreign borrower agree that the taxpayer will repay only the portion of the loan equal to the amount of currency the taxpayer actually purchases.

Finally, the taxpayer exchanges the foreign currency he purchased for United States dollars. That exchange is a taxable event, and the taxpayer claims a loss equal to the full amount of his supposed basis in the CARDS Loan, less the proceeds of the relatively small amount of currency actually exchanged. The taxpayer uses that loss to shelter unrelated income. The general structure of a CARDS transaction is well and thoroughly set forth in Gustashaw v. Commissioner, 696 F.3d 1124, 1127-28, 1130-31 (11th Cir. 2012), (available here)

We have previously blogged about the Gustashaw case, available here. Ultimately, the Third Circuit held in that case as follows: “In this case, there was ample documentary and testimonial evidence that contradicted Crispin’s account of the business purpose of his CARDS transaction, and the Tax Court did not abuse its discretion in deciding  not to credit Crispin’s evidence”¦” Consequently, the taxpayer was not entitled to the ordinary loss deduction.

Interestingly, the Third Circuit noted a circuit split regarding the imposition of the gross valuation misstatement penalty in § 6662(h), available here. A the Third Circuit described:

Our sister circuits are divided as to whether the valuation misstatement penalty applies to tax deductions that have been totally disallowed under the economic substance doctrine. Compare Fidelity Int’l Currency Advisor A Fund, LLC v. United States, 661 F.3d 667, 671-75 (1st Cir. 2011) (holding that the penalty is applicable), Zfass v. Comm’r, 118 F.3d 184, 190 (4th Cir. 1997) (same), Gilman v. Comm’r, 933 F.2d 143, 151 (2d Cir. 1991) (same), and Massengill v. Comm’r, 876 F.2d 616, 619-20 (8th Cir. 1989) (same), with Heasley v. Comm’r, 902 F.2d 380, 383 (5th Cir. 1990) (holding that when the IRS totally disallows a deduction, the underpayment is “not attributable to a valuation overstatement” but rather to claiming an improper deduction), Gainer v. Comm’r, 893 F.2d 225, 228 (9th Cir. 1990) (same), and Todd v. Comm’r, 862 F.2d 540, 543 (5th Cir. 1988) (holding that the penalty was inapplicable when the deficiency was not due to overstated basis but to a failure to place property into service). However, Crispin’s reliance on Todd and Gainer is misplaced because they do not state the law of this Circuit. See Merino v. Comm’r, 196 F.3d 147, 157-159 (3d Cir. 1999) (holding that the valuation misstatement penalty applies to property acquired in a transaction found to lack economic substance and expressly declining to follow Todd and Heasley).

Our reasoning as to the applicability of the valuation misstatement penalty finds support in the recent decision of the United States Court of Appeals for the Eleventh Circuit in Gustashaw, supra. In that case, the taxpayer conceded the tax deficiency that the Commissioner had assessed as a result of the disallowance of a CARDS Loan loss, so the economic substance issue was not before the Court, but the taxpayer contested the penalties. Applying the “majority rule,” the Eleventh Circuit held that the 40 percent penalty applies “even if the deduction is totally disallowed because the underlying transaction, which is intertwined with the overvaluation misstatement, lacked economic substance.” 696 F.3d at 1136. Also, the Fifth and Ninth Circuits “have questioned the wisdom of their positions” in Todd, Heasley, and Gainer because those positions create the “anomalous result” of relieving a taxpayer of the penalty when a deduction is disallowed because it is so egregious that it is improper for a reason other than valuation, such as a lack of economic substance, See Bemont Investments, L.L.C. ex rel. Tax Matters Partner v. United States, 679 F.3d 339, 355 (5th Cir. 2012) (Prado, J., concurring) (noting that the “Todd/Heasley rule,” by “[a]mplifying the egregiousness of the scheme ”” to the point where the transaction is an utter sham ”” could … , perversely, shield the taxpayer from liability for overvaluation”); Keller v. Comm’r., 556 F.3d 1056, 1061 (9th Cir. 2009) (recognizing that the rule as expressed in most Circuits, including Merino, is a “sensible method of resolving overvaluation cases” because it “cuts off at the pass what might seem to be an anomalous result ”” allowing a party to avoid tax penalties by engaging in behavior one might suppose would implicate more tax penalties, not fewer[,]” but acknowledging that, “[n]onetheless, in this circuit we are constrained by Gainer“).

The Crispin case, on its face, looks like a total loss for the taxpayer. However, given that in the Fifth and Ninth Circuits taxpayers can successfully attack the valuation misstatement penalty when the underlying deduction has been totally disallowed by the IRS, the Circuit divide on this issue could provide fertile ground to push back on the IRS in tax shelter litigation. The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience litigating against the IRS and the U.S. Department of Justice in the U.S. Tax Court, the U.S. Court of Federal Claims, the various U.S. District Courts and Courts of Appeals in both civil and criminal tax cases. You can contact us by emailing us at: contact@fidjlaw.com or by telephone at 305.350.5690.

Ernst & Young to Pay $123 Million to Resolve Federal Tax Shelter Fraud Investigation

Ernst & Young has entered a non-prosecution agreement admitting “wrongful conduct by certain E&Y partners and employees in connection with the firm’s participation, from 1999 to 2004, in four tax shelters that were used by approximately 200 E&Y clients in an effort to defer, reduce, or eliminate tax liabilities of more than $2 billion.” The press release from the U.S. Attorney’s Office for the Southern District of New York (which includes Manhattan), is available here. As part of its agreement with the United States, E&Y agreed to pay $123 million to the United States and acknowledged a detailed Statement of Facts in which it admitted the wrongful conduct of certain partners and employees. E&Y also agreed to certain permanent restrictions and controls on its tax practice, including a prohibition against planning, promoting or recommending any “listed transaction.”

Generally, the term “prohibited tax shelter transaction” means listed transactions, transactions with contractual protection, or confidential transactions. When a taxpayer participates in a listed transaction he/she/it must file Form 8886, available here, with the IRS. Treasury Regulations also require taxpayers to disclose listed transactions on their tax returns. The applicable Treasury Regulation is 26 C.F.R section 1.6011-4, available here.

The non-prosecution agreement also requires E&Y’s continued cooperation with the Government’s investigation. In exchange, the United States agreed not to criminally prosecute E&Y for its participation in the tax shelter scheme. The agreement applies only to E&Y and not to any individuals. E&Y has cooperated with the Government’s investigation into these tax shelters since approximately 2003. In the event that the firm violates the NPA, the U.S. Attorney’s Office may prosecute E&Y.

E&Y admitted to the following facts:

Beginning in 1999 and ending in 2002, E&Y, in conjunction with various law firms, banks, and investment advisers, developed, marketed and implemented four tax shelter products called COBRA, CDS, CDS Add-On, and PICO. E&Y implemented these four tax shelter products for approximately 200 high net worth clients in an effort to defer, reduce, or eliminate $2 billion in aggregate tax liabilities. E&Y prepared tax returns reflecting tax losses claimed to have been derived from those tax shelter products and subsequently defended certain of its clients in connection with audits of those transactions by the IRS.

A small group within E&Y known as the Strategic Individual Solutions Group (“SISG”) was primarily responsible for supervising and coordinating the marketing, implementation and defense of E&Y’s tax shelter products. Certain SISG tax shelter products were designed to appear to the IRS to be substantive investments that had favorable tax consequences when, in reality, the products were actually designed and marketed to clients as a series of preplanned steps that would defer, reduce or eliminate their tax liabilities. The typical client participating in these shelters was primarily, if not exclusively, motivated to achieve a desired tax savings.

In order to deceive the IRS as to the true nature of the tax strategies, and to bolster arguments that the transactions had economic substance, some SISG personnel agreed upon and directed other E&Y employees to participate in a concerted effort not to create, disseminate, or publicize documents reflecting the tax motivation behind the strategies, or the preplanned sequence of steps necessary to effect the strategies. These SISG personnel thereby sought to prevent the IRS from detecting their clients’ purposes in employing these strategies. For example, in certain instances, members of SISG falsely portrayed the transactions under examination as purely investment-driven transactions, and falsely denied a tax motivation for the transactions in response to IRS Information Document Requests and in testimony to the IRS.

Further, in implementing the sale of tax shelter products, certain members of SISG also prepared documents or correspondence that falsely and inaccurately reflected events or conversations, and that were designed to improperly influence the IRS’s view of the merits of the transactions in the event of an audit. These activities continued into 2003 and 2004.

The Ernst & Young case demonstrates that the U.S. Department of Justice together with the IRS will continue to attack tax shelters from every possible angle, including the taxpayers themselves and the professionals designing and promoting the tax shelters. The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience litigating against the IRS and the U.S. Department of Justice in the U.S. Tax Court, the U.S. Court of Federal Claims, the various U.S. District Courts and Courts of Appeals in both civil and criminal tax cases. You can contact us by emailing us at: contact@fidjlaw.com or by telephone at 305.350.5690.

Business Litigation Update: The Economic Loss Rule Exiled to its Humble Beginnings

Florida’s “economic loss doctrine” (or, the “Rule”), which bars recovery in tort where a contract exists between the parties, is one of Florida’s most hotly contested legal doctrines. The doctrine appears to be fluid, changing with the times and sculpted on a case-by-case basis. Florida’s Supreme Court has expended inordinate time creating, expanding, retracting, retreating, narrowing, and reclassifying the doctrine over the past twenty-five years.

On March 7, 2013, in Tierra Condominium Ass’n vs. Marsh & McLennan Cos., SC10-1022, 38 Fla. L. Weekly S151a (March 7, 2013), the Florida Supreme Court announced the bright line rule for its narrow applicability: “[T]he application of the economic loss rule is limited to products liability cases. Therefore, we recede from prior case law to the extent that it is inconsistent with this holding.” The Tierra decision can be read in full here.

The economic loss rule is a judicially created doctrine whose roots are found in product liability litigation. In East River Steamship Corp. v. Transamerica Delaval, Inc., 476 U.S. 858, 871 (1986), the United States Supreme Court determined that tort law should not, absent loss to person or personal property, supplant warranty law. Borrowing from East River, the Tierra Court noted, “when the damage is to the product itself, ”˜the injury suffered — the failure of the product to function properly — is the essence of a warranty action, through which a contracting party can seek to recoup the benefit of its bargain.’” The Court continued:

Contract law, and the law of warranty in particular, is well suited to commercial controversies of the sort involved in this case because the parties may set the terms of their own agreements. The manufacturer can restrict its liability, within limits, by disclaiming warranties or limiting remedies. In exchange, the purchaser pays less for the product.

Id. (citing East River at 872-73 (emphasis in original). With the intention to avoid “contract law . . . drown[ing] in a sea of tort,” the Supreme Court held that “a manufacturer in a commercial relationship has no duty under either a negligence or strict products-liability theory to prevent a product from injuring itself.” Id.  The Florida Supreme Court adopted this reasoning in Florida Power & Light Co. v. Westinghouse Elec. Corp., 510 So. 2d 899 (Fla. 1987), and reiterated its application in Casa Clara Condominium Ass’n, Inc. v. Charley Toppino and Sons, Inc., 620 So. 2d 1244 (Fla. 1993) (the economic loss rule is “the fundamental boundary between contract law, which is designed to enforce the expectancy interests of the parties, and tort law, which imposes a duty of reasonable care and thereby encourages citizens to avoid causing physical harm to others.”).

From there, Florida jurisprudence was engulfed in a “sea of litigation” over the expansion of the principles. Virtually every tort was attacked by creative defense counsel in every facet of civil transactions. Defense counsel continuously endeavored to ensure victims were limited to fundamental contractual remedies, whereas equally creative plaintiffs’ counsel fought to poke holes in the judicially created rule. Cases dragged on for years, and the appellate courts reported mixed and confusing decisions interpreting the reach of the Rule.

In 1996, the Florida Supreme Court tried to resolve the “sea of confusion” in HTP, Ltd. v. Lineas Aereas Costarricenses, S.A., 685 So.2d 1238, 1239 (Fla. 1996), by holding, “Where a contract exists, a tort action will lie for either intentional or negligent acts considered to be independent from acts that breached the contract.” The next phase of litigation thus circumnavigated the emerging confusion over the word “independent.”

Volumes of opinions centered around what constituted “independence.” Reasoned jurists addressed the distinctions between “fraud in the performance,” which was the judicial equivalent of breach of contract, with “fraud in the inducement,” which translated into the common law fraud designed to induce one to enter into the contract, and thus independent from the contractual breach. See, i.e., Hotels of Key Largo, Inc. v. RHI Hotels, Inc., 694 So.2d 74, 78 (Fla. 3d DCA 1997). Individual courts then attempted to create bright line rules on what exactly determined whether a “fraud” claim was independent from the essence of the parties’ agreement. See Dantzler Lumber & Export Co. v. Bullington Lumber Co., Inc., 968 F.Supp. 1543, 1546-47 (M.D. 1997), Samuels v. King Motor Co. of Fort Lauderdale, 782 So.2d 489, 498 (Fla. 4th DCA 2001).

Likewise, courts of every district were asked to decide whether the Rule proscribed statutory causes of action when a contract co-existed between the parties. The Florida Supreme Court resolved the conflicts in Comptech International, Inc. v. Milam Commerce Park, Ltd., 753 So. 2d 1219 (Fla. 1999). In addition, the courts were asked to review whether professional negligence cases against professionals would survive when the professional was engaged pursuant to a contract. The Supreme Court announced the final rule in Moransais v. Heathman, 744 So. 2d 973, 984 (Fla. 1999). In short, virtually every commercial tort has been under attack by the Rule since its indoctrination into Florida jurisprudence, and the Supreme Court has regularly been called upon to end divisive conflict.

Having had enough, the Florida Supreme Court decided to fully retreat from the over-expansion of the Rule, and return its use to its original products liability beginnings. The Court explicitly held:

Having reviewed the origin and original purpose of the economic loss rule, and what has been described as the unprincipled extension of the rule, we now take this final step and hold that the economic loss rule applies only in the products liability context. We thus recede from our prior rulings to the extent that they have applied the economic loss rule to cases other than products liability.

Tierra, supra.

Now that our Court has made this bold move, what does it mean?  Will our courts drown contract law in “a sea of torts”?  Probably not.  Even before the Economic Loss Rule Revolution, our courts recognized the limitations against suing for tort theories when no duty has been breached apart from breach of contract.  See Weimar v. Yacht Club Point Estates, 223 So.2d 100 (Fla.1969) (where defendant has not committed a breach of duty apart from breach of contract there can be no action in tort); Ginsberg v. Lennar Florida Holdings, Inc., 645 So. 2d 490, 495 (Fla. 3d DCA 1994); See further Ginsberg v. Lennar Fla. Holdings, Inc., 645 So. 2d 490, 494 (Fla. 3d DCA 1994) (“Where damages sought in tort are the same as those for breach of contract a plaintiff may not circumvent the contractual relationship by bringing an action in tort.”); Rosen v. Marlin, 486 So. 2d 623, 626 (Fla. 3d DCA 1986)(“Where the compensatory damages requested in a count for tort are identical to the compensatory damages sought in a count for breach of contract, compensatory damages and punitive damages for the tort are not recoverable.”); Rolls v. Bliss, 408 So.2d 229 (Fla. 3d DCA 1981) (award of contractual damages may not form basis for an award of tort damages), review dismissed, 415 So.2d 1359 (Fla.1982); Overseas Equipment Company, Inc. v. AcerosArquitectonicos, 374 So.2d 537 (Fla.3d DCA 1979) (same).  However, wherever there is a rule, there stands a clever lawyer waiting to punch holes and create exceptions.

Stay tuned for future developments.

Update: IRS Continues To Use Anti-Drug Trafficking Tax Code Provision To Limit The Ability Of Marijuana Dispensaries to Deduct Business Expenses

As we have previously reported, despite the growing number of States (18 in total) that have sanctioned the use of marijuana in various forms, the federal government has continued its efforts to crack down on dispensaries. (Our recent articles discussing these efforts can be read here, here, and here.). In addition to prosecutions for violating federal law, federal authorities have used various other techniques in an effort to quash the burgeoning marijuana industry. One such technique disallows marijuana dispensaries from taking business deductions on their federal income taxes pursuant to 26 I.R.C. § 280E.

26 I.R.C. § 280E states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Pursuant to this statute, federal income tax deductions for business expenses commonly used by small businesses (such as deductions for office rent or mortgage payments, electricity, phone and internet services) are not available to state sanctioned marijuana dispensaries because they are still deemed by federal authorities to violate the Controlled Substances Act.

In response, the IRS issued a series of letters to the Congressmen strongly refuting their position:

Section 280E of the Code disallows deductions incurred in the trade or business of trafficking in controlled substances that federal law or the law of any state in which the taxpayer conducts the business prohibits. For this purpose, the term “controlled substances” has the meaning provided in the Controlled Substances Act. Marijuana falls within the Controlled Substances Act. See Californians Helping to Alleviate Medical Problems, Inc. v. C.I.R., 128 T.C. No. 14 (2007). The United States Supreme Court has concluded that no exception in the Controlled Substances Act exists for marijuana that is medically necessary. U.S. v. Oakland Cannabis Buyers Co-op., 532 U.S. 483 (2001).

The effect of 280E can be drastic on dispensaries. According to a recent CNNMoney report, the inability of dispensaries to take business deductions has resulted in dispensaries paying an effective tax rate as high as seventy-five percent (75%). The practical effect of this massive tax burden makes business operations difficult, if not impossible.

However, beginning in 2010, IRS’s use of Section 280E to deny marijuana dispensaries the ability to deduct business expenses has come under increased scrutiny. In November of 2010, a group of U.S. Congressmen led by Rep. Pete Stark of California sent a letter to the IRS explaining that “the legislative intent, in drafting [280E], was to deny the benefit of tax deductions and credits to those who violate our laws against trafficking in illegal drugs,” not to prohibit businesses which are compliant with state or local laws from deducting business expenses. The Congressmen requested that the IRS issue a revenue ruling holding that “deductions or credits shall be allowed for amounts paid or incurred during the taxable year in the carrying on of a trade or business if the activities which comprise the trade or business are conducted in compliance with state or local law.” A copy of the letter can be read here.

The IRS’s letter concluded that “because neither section 280E nor the Controlled Substances Act makes exception for medically necessary marijuana, we lack the authority to publish the guidance that you request. The result you seek would require the Congress to amend either the Internal Revenue Code or the Controlled Substances Act.” A copy of the IRS’s letter can be read here.

In response to this letter, on May 25, 2011, Rep. Stark introduced H.R. 1985, the Small Business Tax Equity Act of 2011, which would have amended the Internal Revenue Code to allow for a deduction for expenses in connection with the trade or business of selling marijuana intended for patients for medical purposes pursuant to State law. However, the bill died in the House Ways and Means Committee and did not make it to the floor for a vote.

Thus, as it now stands, while the threats of criminal prosecution and asset seizure for marijuana distribution are undoubtedly severe, the IRS’s current interpretation of 280E could have an equally devastating impact on the industry.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of administrative law, constitutional law, regulatory compliance, white collar criminal defense and litigating against the IRS and the U.S. Department of Justice. You can reach an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.

Customs Sharing Hard Times with Importers and Travelers

Sequestration budget cuts only add to CBP’s focus on increasing revenues.

While much has been made in the press about the effect of the sequestration on U.S. Customs and Border Protection (CBP), with experts and even CBP officials anticipating longer lines at immigration check-points and longer times to clear cargo, the sequestration is only another thorn in the budgetary side of CBP. And CBP seems to want to share that pain with importers and travelers alike.

Some Historical Perspective

While CBP’s official mission statement discusses such noble (and critical) roles as guarding our nation’s borders and protecting us against terrorists and instruments of terror, it also mentions “ fostering our Nation’s economic security through lawful international trade and travel.” What do these words mean? Money.

Many people do not realize that the second act of the 1st Congress of the United States, passed on July 4, 1789, authorized the collection of duties and tariffs on imports. Twenty-seven days later, the fifth act of that first Congress established the progenitor of CBP to collect those duties. Congress created Customs (CBP) even before the Bill of Rights.

The reason for this Congressional urgency was money. In 1789, the nation desperately needed to pay the costs of the Revolutionary War. In fact, since 1789, with the exception of temporary taxes and bonds to fund little government projects like the War of 1812 and the Civil War, the sole source of revenue for the U.S. Government was customs duties. This was true for the first 124 years of our nation’s existence, up until the passage of the Sixteenth Amendment in 1913, which established the income tax systems we know today.

With collecting money so firmly rooted in its DNA, it stands to reason that when economic times get hard for CBP, it returns to its roots and its mission of “economic security.” And now with the sequestration, times are hard for CBP.

Sequestration Squeezes the Agency

Under current sequestration provisions, CBP will have to cut $754 Million, or roughly 6.5% of its budget. The Agency reports that an immediate consequence will be deep cuts in overtime pay for its CBP officers and staff. These cuts, combined with 12-14 day furloughs, means that fewer inspectors will be available at immigration checkpoints, and fewer officers will be available to clear incoming cargo. In addition, we can expect to see longer processing times for bonded-activity applications (like bonded warehouses and container freight stations) and for adjudications of protests and fines, penalty and forfeiture cases.

But these proposed and hypothesized cuts only tell half of the story.

As budgetary times have become harder for the Agency and perhaps in anticipation of the sequestration, we have seen a significant trend in those CBP fines, penalty and forfeiture cases as well as in its adjudication of rulings affecting duties and tariffs. The bottom line is that CBP is looking for more money from its enforcement measures.

Take offers-in-compromise, for example. In penalty cases, if an importer is unable to pay a proposed or levied penalty, the importer can make an offer-in-compromise to the Agency. The importer offers to pay a percentage of the penalty, and usually provides documentation (tax, sales, and banking records) describing the financial straits that render the importer unable to pay the full amount. In years gone by, depending on the circumstances, CBP has been willing to accept pennies on the dollar, often approving offers for 5% – 25% of the original penalty amount.

Recently, however, we have seen offers as high as 50% and 67% of a penalty amount refused by CBP, even though the importer in each case provided documentation that it has steadily lost money in each of the prior three years and didn’t have enough money in the bank to cover the full amount of the penalties. When pressed for additional information on these rejected offers, CBP sources confirmed that the Agency is seeking higher revenues these days. This same mindset explains the trends we have seen in recent months of reduced mitigation of liquidated damages and claims for higher initial penalties than would have been previously expected.

At the same time, we are seeing increased enforcement and revenue collection efforts across a variety of avenues. More and more CBP officers are screening both incoming and outgoing travelers for currency and monetary instrument reporting compliance. Also, the Agency has been challenged by Congress to better enforce antidumping and countervailing duty collection.

The bottom line for importers and travelers for CBP’s budget woes is this: it will take longer to get you and your products into the United States, and if you break any laws, the penalties will be higher and the levels of possible forgiveness will be lower. And if the current negotiations on the sequestration are any indication, we should expect this new status quo for the foreseeable future.

IRS Issues Guidance for Native Americans Regarding Tribal Trust Settlements

The IRS recently issued guidance in the form of Notice 2013-1, available here, that provides guidance on federal tax treatment of certain per capita payments made to members of Indian tribes. The background for the Notice is as follows:

The United States has entered into agreements with federally recognized Indian tribes, settling litigation in which the tribes alleged that the Department of the Interior and the Department of the Treasury mismanaged monetary assets and natural resources the United States holds in trust for the benefit of the tribes (“Tribal Trust cases”). Upon receiving the settlement proceeds, the tribes will dismiss their claims with prejudice. See Press Release, U.S. Department of Justice, Attorney General Holder and Secretary Salazar Announce $1 Billion Settlement of Tribal Trust Accounting and Management Lawsuits Filed by More Than 40 Tribes (April 11, 2012), available here.

Although agreeing to settlements, the United States has admitted no liability and has no fiduciary responsibilities over the Tribal Trust case settlement proceeds that the tribes receive and that are deposited into accounts at private banks or other third-party institutions.

The applicable law is as follows.

Section 61(a) of the Internal Revenue Code, available here, provides that, except as otherwise provided by law, gross income means all income from whatever source derived. Native Americans are citizens subject to the payment of income taxes; see Squire v. Capoeman, 351 U.S. 1, 6 (1956), available here. The Per Capita Act, Pub. L. No. 98-64, 97 Stat. 365, available here, and 25 U.S.C. §§ 117a through 117c, available here

provide authority to Indian tribes to make per capita payments to Indians out of tribal trust revenue. The Indian Tribal Judgment Funds Use or Distribution Act, 25 U.S.C. §§ 1401 through 1408, available here, concerns the distribution of certain judgment funds to Indian tribes. Under 25 U.S.C. § 117b(a), available here, funds distributed under 25 U.S.C. § 117a are subject to the provisions of 25 U.S.C. § 1407. Under 25 U.S.C. § 1407, the funds described in that section, and all interest and investment income accrued on the funds while held in trust, are not subject to federal income taxes. For federal income tax purposes, per capita payments that an Indian tribe makes from the tribe’s Tribal Trust case settlement proceeds are treated the same as per capita payments from funds held in trust by the Secretary of the Interior under 25 U.S.C. § 117a

The IRS announced that under 25 U.S.C. § 117b(a), per capita payments made from the proceeds of an agreement between the United States and an Indian tribe settling the tribe’s claims that the United States mismanaged monetary assets and natural resources held in trust for the benefit of the tribe by the Secretary of the Interior are excluded from the gross income of the members of the tribe receiving the per capita payments. But per capita payments that exceed the amount of the Tribal Trust case settlement proceeds and that are made from an Indian tribe’s private bank account in which the tribe has deposited the settlement proceeds are included in the gross income of the members of the tribe receiving the per capita payments under § 61.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience litigating against the IRS and the U.S. Department of Justice and have appeared before the U.S. Tax Court, the various U.S. District Courts, the U.S. Court of Federal Claims, and the various U.S. Courts of Appeal. You can contact an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.