Third Circuit Court of Appeals Reverses Tax Court in Sunoco Inc. v. Commissioner of Internal Revenue

Last month, the Third Circuit reversed the judgment of the Tax Court which held that the Tax Court had jurisdiction over Sunoco’s claim that it was entitled to interest on tax overpayments. In reversing the decision of the Tax Court, the Third Circuit held that either the U.S. District Courts or the Court of Federal Claims have jurisdiction over claims that the United States owes interest on overpayments.

The relevant facts are as follows:  On July 1, 1997, the IRS issued a notice of deficiency to Sunoco for the tax years 1979, 1981, and 1983. The IRS claimed deficiencies of income tax in the amounts of $10,563,157.00, $5,163,449.00, and $35,916,359.00 respectively, for a total amount of $51,642.965.00. Sunoco responded to the notice of deficiency by filing a timely petition in the Tax Court in which it contested the IRS determination of deficiencies for 1979, 1981, and 1983. It also asserted that it had made income tax overpayments for those years totaling $46,100,857.00. Sunoco sought a refund of the overpayment together with interest.

Thereafter, in November of 1997, Sunoco amended its petition to add, inter alia, allegations relating to certain errors that Sunoco claimed the IRS had made in computing underpayment and overpayment interest. Sunoco alleged that for each of the disputed years, the interest the IRS had charged on underpayments pursuant to I.R.C. § 6601 was too high, and the interest the IRS had paid to Sunoco on overpayments pursuant to I.R.C. § 6611 was too low.

In March of 2000, the IRS moved to dismiss Sunoco’s amended petition to the extent that it asked the Tax Court to order the IRS to pay additional overpayment interest under I.R.C. § 6611. The IRS contended that Sunoco’s claims for overpayment interest for the taxable years 1979, 1981, and 1983 must be dismissed for lack of jurisdiction [because] the Tax Court does not have jurisdiction to determine the amount of interest due on overpayments allowed prior to the commencement of the case.

In an opinion dated February 4, 2004, the Tax Court denied the IRS motion to dismiss, holding that it had jurisdiction to determine interest with respect to overpayments where the overpayments and interest on overpayments had been refunded to the taxpayer or otherwise credited to the taxpayer’s account before the case arrived in the Tax Court. Sunoco, Inc. and Subsidiaries v. Commr of the IRS, 122 T.C. 88 (2004). A full copy of the Tax Court decision can be found here.

In overturning the decision of the Tax Court, the Third Circuit discussed the two types of interest, interest on tax underpayment and interest on overpayments.  Interest on tax underpayments is known as deficiency interest.  See I.R.C. section 6601.  Interest on overpayments is known as overpayment interest.  See I.R.C. section 6611.  The Tax Court has jurisdiction to determine interest on underpayments (deficiency interest).  See I.R.C. section 6512(b).  However, a claim for overpayment interest is a general monetary claim against the United States, which (like all such claims) must be brought in the federal district courts or the Court of Federal Claims within the six-year limitations period set forth in 28 U.S.C. §§ 2401 (district court) and 2501 (Court of Federal Claims). Consequently, the Third Circuit reversed the Tax Court’s decision that it had the requisite decision to hear Sunoco’s claim that it was entitled to interest on tax overpayments.

The significance of this decision is that a taxpayer must properly ascertain what time of interest deficiency vs. overpayment is involved in a particular dispute.  Failure to properly bring an action in the appropriate court could lead to a case being dismissed for lack of jurisdiction.  Moreover, if a case is brought in the wrong court, by the time a decision is rendered it may be too late to refile with the appropriate court.

A full copy of the Third Circuit’s decision can be found here

The attorneys at Fuerst Ittleman, PL have extensive experience litigating against the government in the Tax Court, the District Courts, the Court of Claims, and the Circuit Courts.  You can contact at contact@fidjlaw.com.

Office of Financial Regulation’s MSB Facilitated Workers’ Compensation Fraud Work Group Issues Report and Recommendation to Florida House; Draws Criticism from Legislators.

On November 2, 2011, Floridas Office of Financial Regulations “MSB Facilitated Workers Compensation Fraud Workgroup” presented its much anticipated report and recommendations to the Florida House of Representatives Insurance and Banking Subcommittee. The report focused on recommendations for combating workers compensation fraud facilitated by Florida check-cashers. A copy of the report and recommendations can be read here.

As we previously reported, on August 2, 2011, the Financial Services Commission of the Florida Office of Financial Regulation (“OFR”) issued a report to Governor Rick Scott and his Cabinet regarding workers compensation fraud in the State of Florida. The cabinet report revealed that money services businesses have played an active, critical, and sometimes unknowing part in defrauding the workers compensation insurance market. A complete overview of the fraud scheme can be read here.

At that time, Florida C.F.O. Jeff Atwater announced the creation of a workgroup to study the issue of MSB facilitated workers compensation fraud and to make recommendations to combat the issue. Over the next several months, the workgroup met four times to analyze ways to combat the fraud scheme and develop comprehensive reforms. The November 2, 2011 presentation of the workgroups report and recommendations was the product of these meetings.

The workgroup provided several consensus recommendations to combat MSB facilitated workers compensation fraud. First, the workgroup called for the creation of a real-time database for check cashing transactions above $1,000. The workgroup reasoned that because shell corporations which drive workers compensation fraud incorporate and dissolve quickly, time is of the essence in detecting a fraud scheme. A real-time database would provide the OFR with the amount of the cashed check, the cashing entitys workers compensation policy number and other information currently required to be within a check cashers electronic logs. OFR would then compare this information with the amount of payroll reported to the insurer, thus indicating potential fraud schemes when reported payroll and total amounts of checks cashed differed.

The workgroup also recommended that that OFR be given the authority to make unannounced visits to inspect MSBs. Currently, Florida law prohibits unannounced visits and requires that OFR provide at least 15 days notice prior to inspection. See § 560.109, Fla. Stat. As explained by the workgroup, “the announcement of an exam or investigation allows unscrupulous licensees to hide, destroy, or otherwise tamper with the evidence that the [OFR] may collect in the course of the visit.”

The workgroup also recommended that the Legislature require licensed check cashers to provide the workers compensation policy number, under which a corporate payment instrument is cashed, to the OFR. This requirement would allow the OFR to compare estimated payroll reported on the policy with the amount and number of checks that are cashed for a policyholder and will enable regulators to more readily identify premium avoidance schemes.

Other consensus workgroup recommendations included: 1) requiring the Division of Workers Compensation to include payroll information of policy holders on its proof of coverage website; 2) modifying the check cashing statute, found at § 560.303, Fla. Stat. et seq., to require licensees to maintain a depository bank account for the purpose of negotiating all cashed checks in order to simplify audit trails; and 3) eliminating the mandatory six-month examination of new licensees, but still require examination “as soon as practicable” to allow OFR to focus regulatory resources on high priority cases.

The workgroup also provided several other recommendations which were not fully supported by the workgroup. The non-consensus recommendations included: 1) eliminating the ability to cash checks when the payee is a corporate entity or a third-party or set a threshold limit for the dollar amount allowable for such checks to be eligible for cashing; and 2) changing how certificates of insurance are issued by requiring that certificates be issued by the OFR.

Although the workgroup presented a host of recommendations, its inability to reach consensus on all recommendations drew criticism from subcommittee members. Additionally, the workgroups report drew criticism from some subcommittee members because the representatives did not feel the recommendations went far enough.

Fuerst Ittleman will continue to monitor this situation with a keen eye as implementation of the workgroups recommendations could result in changes to regulatory compliance for the Florida MSB industry. If you have questions pertaining to Floridas Office of Financial Regulations, the BSA, anti-money laundering compliance, or how to ensure that your business maintains regulatory compliance at both the state and federal levels, please contact us at contact@fidjlaw.com

Second Circuit Overturns Conviction for Violation of Iranian Transactions Regulations and Operation of an Unlicensed Money-Transmitting Business

On October 24, 2011, the United States Court of Appeals for the Second Circuit issued its decision in United States v. Banki overturning the conviction of Mahmoud Reza Banki for violating trade sanctions with Iran and operating an unlicensed money-transmitting business. In this case, authorities alleged that Banki violated the ITR and 18 U.S.C. § 1960, which prohibits the operation of unlicensed money-transmission businesses, for his role in 56 money transfers to Iran through the informal money transmission system known as “hawala” which is widely used throughout the Middle East and South Asia. In the hawala system funds are transferred from one country to another through a network of hawala brokers known as “hawaladars.”

As previously reported, the ITR, which are found at 31 C.F.R. part 560, were promulgated pursuant to the International Emergency Economic Powers Act and are administered by OFAC.  31 C.F.R. § 560.204 prohibits the exportation, reexportation, sale, or supply, directly or indirectly, from the United States, or by a United States persons, of any goods, technology, or services to Iran unless “otherwise authorized” in 31 C.F.R. part 560. Pursuant to 17 U.S.C. § 1705, persons who willfully violate the ITR are subject to criminal penalties.

There are numerous forms of hawala but the two discussed by the Court were the “paradigmatic” system and the “match” system. The “paradigmatic” system works as follows: person 1 located in country A who wants to send money, for example $100, to person 2 in country B would contact a hawaladar located in country A and would pay the country A hawaladar the $100. Next the country A hawaladar would contact a country B hawaladar and ask the country B hawaladar to pay $100 in country Bs currency, minus any fees, to person 2. In the future, when country B hawaladar needs to send money to country A, he will then contact the country A hawaladar, with whom he now has a credit because of the previous transaction, and the country A hawaladar will complete the transaction. Normally, a number of transactions must be completed in order to balance the books between the two hawaladars and periodic settlement of the imbalances occurs via wire transfers or more formal money transmission methods. In this way, people can remit money to others without any actual money crossing the border between country A and country B.

The “match” system works on a similar premise. Under the match system, country As hawaladar seeks out a country B hawaladar looking to transmit money to a third party in country A. Once a “match” occurs, country Bs hawaladar would pay person 2 and then, upon knowledge of payment to person 2, country As hawaladar would pay the third party. Hawaladars derive their profits from the difference in the “buy” and “sell” exchange rates on completed transactions.

The use of the hawala system in the United States to remit funds to and from Iran is problematic for several reasons. First, transferring funds through a hawala qualifies as “money transmitting” under 18 U.S.C. § 1960. Therefore, hawaladars, which typically operate without licenses, are operating illegal money transmitting businesses and are thus in violation of 18 U.S.C. § 1960. As such, U.S. patrons of hawaladars may also be charged for using hawala in the U.S. Second, because money transmission is considered a “service” under the ITR, it is a violation of the Iranian sanctions to transfer money to Iran unless the transfer arises as part of an underlying transaction that is not prohibited.

In Bankis case, authorities alleged that Bankis family members in Iran engaged in 56 money transfers using a match hawaladar to transfer assets to Banki in the United States. Authorities further alleged that for each deposit made into Bankis U.S. bank account, a corresponding payment was sent to Iran for a third party. Additionally, although the funds being transferred into Iran were not Bankis, authorities alleged that Banki knew that for each deposit he received there was a corresponding payout in Iran. Thus, based on this knowledge, authorities alleged that Banki facilitated an American hawaladar in violating the IRT and in operating an unlicensed money-transmitting business.

Authorities charged Mr. Banki with: 1) conspiring to violate the ITR and operate an unlicensed money-transmitting business; 2) violating or aiding and abetting the violation of the IRT; 3) conducting or aiding and abetting the conduct of an unlicensed money-transmitting business; and 4) two counts of making materially false representations in response to an OFAC administrative subpoena. In May of 2010, Banki was found guilty of all counts and was sentenced to 30 months imprisonment and ordered to forfeit $3.4 million.

On appeal, Banki argued his conviction should be overturned for several reasons. First, Banki argued that executing money transfer to Iran on behalf of others only violates the ITR if undertaken for a fee. Second, he argued that even if hawala transfers are considered a service, non-commerical remittances, including family remittances like the ones in this case, are exempt from the service ban. Third, Banki argued his aiding and abetting of an unlicensed money transmitting business should be overturned because the trial court failed to instruct the jury that participation in a single, isolated transmission of money does not constitute a money transmission business.

In its decision, the Second Circuit provided a detailed analysis of Bankis arguments which will guide future IRT and 18 U.S.C. § 1960 cases. First, the Court found that because the IRT was designed to be a broad and overinclusive sanctions scheme designed to isolate Iran, “the transfer of funds on behalf of another constitutes a Ëœservice even if not performed for a fee.”

Although money transmittal for no fee is still considered a “service” under the ITR, the Court went on to find that 31 C.F.R. § 560.516, which provides that non-commercial remittances, such as family remittances, are exempt from the services ban, is ambiguous as to whether it applies to all instances of non-commercial remittances or only those which take place in depository institutions. In so holding, the Court found that the governments argument that U.S. depository institutions have exclusive authority to process family remittances is inconsistent with the language of the regulation. However, the Court also found that, based on the statutory and regulatory sanctions scheme in place, Bankis argument that anyone, including hawalas, could process a non-commercial remittance is inconsistent with the ITR scheme as a whole. Thus, based on the ambiguity of the breadth of the non-commercial remittance exemption, the Court overturned Bankis convictions for conspiracy and violations of the ITR.

The Court also vacated Bankis conspiracy and aiding and abetting of an unlicensed money transmitting business and remanded for a new trial. In so ruling, the Court agreed with Banki and stated that “to find a defendant liable for operating [or aiding and abetting] an unlicensed money transmitting business, a jury must find that he participated in more than a Ëœsingle, isolated transmission of money.” The Court found that because the evidence presented at trial only showed Bankis knowledge of “match” funds moving to Iran in one transaction, a jury instruction stating that participation in a single, isolated transmission of money does not constitute a money transmission business was appropriate. The trial courts failure to provide the jury with such an instruction was reversible error.

The Second Circuit further held that the lower court also erred in instructing the jury that hawala is both an informal money transfer system and a money transmitting business. The Court found that by so instructing the jury, the district court relieved the government of its burden of proving that Banki had knowledge that more than one transmission had occurred. As explained by the Court, “by later instructing the jury that Ëœa hawala is a money transmission business, the district court arguably was instructing the jury that if it found that Banki operated a hawala, then he necessarily operated a money transmitting business, thereby taking the latter issue away from the jury.” Thus, the Second Circuits opinion distinguishes between the use of a system of money transmission and the operation of a money transmission business.

Although the Court overturned Bankis convictions for conspiracy and aiding and abetting, it disagreed with Bankis argument that he was entitled to an “mere customer or beneficiary” instruction. In his appeal, Banki argued that he should not be held liable for conspiracy or adding and abetting because he was “mere customer or beneficiary” and thus exempt from criminal liability. However, the Court found that Banki was charged with aiding and abetting the facilitation of funds to Iran and not with receiving funds from Iran. Thus, because Banki was charged as the facilitator of the transfer he was an intermediary, not a customer, and thus the instruction would be inappropriate. As explained by the Court, “put simply, where the crime charged is transmitting money to Iran without a license, the Ëœcustomer is the wire originator and/or the intended recipient” not the intermediary.

The opinion is noteworthy not only because it is illustrative of the potential criminal charges Iranian sanction violators may face, but also because of the Courts detailed analysis of the Iranian Transactions Regulations (“ITR”) and the federal money transmitting laws. If you have questions pertaining to the OFAC sanctions on trade with Cuba and Iran, the BSA, anti-money laundering compliance, or how to ensure that your business maintains regulatory compliance at both the state and federal levels, please contact us at contact@fidjlaw.com.

Tax Court rules against corporate taxpayers who relied on advice from in-house professional

On June 7, 2011, Judge Foley in writing for the Tax Court held that corporate taxpayers cannot rely on the advice of a tax professional as a reasonable cause defense to penalties when the tax professional is an employee of the taxpayer.  The case was decided on a consolidated basis with the cases captions of Seven W. Enterprises, Inc. & Subsidiaries, v. Commissioner, and Highland Supply Corp. & Subsidiaries, v. Commissioner.

The facts are relatively straight-forward.  From February 2001 until March 2002, the tax professional worked as an outside consultant for the taxpayers.  During this period, the tax professional prepared Sevens 2000 tax return and Highlands 2001 tax return. In March 2002, both taxpayers hired the tax professional as their vice president of taxes. As  the taxpayers vice president of taxes, the tax professional prepared and signed, on behalf of the taxpayers, Sevens 2001, 2002, and 2003 tax returns and Highlands 2002, 2003, and 2004 tax returns. In 2000 through 2004, the taxpayers incorrectly concluded that they were not liable for personal holding company taxes and, as a result, understated their tax liabilities relating to those years.  The IRS  issued Seven a notice of deficiency relating to 2000 through 2003 and Highland a notice of deficiency relating to 2003 and 2004. In the notices, the IRS determined that the taxpayers were liable for accuracy-related penalties.

The taxpayers contend that they had reasonable cause for their underpayments and acted in good faith. Alternatively, the taxpayers contend that they reasonably relied on the advice of the tax professional in 2000 when the tax professional served as an outside consultant and in 2001 through 2004 when he served as vice president of taxes.

The Tax Court explicitly held that pursuant to sec. 1.6664-4(b)(1) and (c)(1), Income Tax Regs., Seven is not liable for an accuracy-related penalty relating to 2000 because it reasonably relied on the then outside consultant/tax professional to prepare its tax return.  The Tax Court further held that the then in-house tax professional does not qualify as “a person, other than the taxpayer”, pursuant to sec. 1.6664-4(c)(2), Income Tax Regs., with respect to the returns which he signed on behalf of taxpayers, and therefore the aforementioned regulation is not applicable to the taxpayers underpayments of taxes relating to 2001 through 2004.  The Tax Court finally held that the taxpayers were liable for accuracy related penalties relating to 2001 through 2004.

Treas. Reg. 1.6664-4 provides that:  (a) In general. No penalty may be imposed under section 6662 with respect to any portion of an underpayment upon a showing by the taxpayer that there was reasonable cause for, and the taxpayer acted in good faith with respect to, such portion.  The full text of the regulation can be found here.

In general, a penalty defense is a factually intensive analysis and will be unique to each individual taxpayer.  However, the over-riding principle is the extent that a taxpayer attempted to properly report and calculate the taxes due for each taxable year will determine if penalty relief is applicable. 

The full decision can be found here.

The implication of this decision is that reliance on in-house professionals is not a defense to penalties, and as a result, taxpayers need to consult with outside professionals on tax treatment as reflected on their income tax returns.  The attorneys at Fuerst Ittleman have extensive experience advising individuals, partnerships, and corporations on all aspects of the Internal Revenue Code and have extensive experience litigating against the IRS.  You can reach an attorney by emailing us at:  contact@fidjlaw.com.

Tax Court Finds no “reasonable cause” for income omission where taxpayer provided information to and relied on tax return preparer

In Woodsum v. Commission, 136 T.C. No. 129 (June 13, 2011), Judge Gustafson addressed the taxpayers’ petition for redetermination of accuracy-related penalty of $104,295 that the Internal Revenue Service (IRS) determined against the taxpayers for tax year 2006, pursuant to section 6662(a). The issue for decision was whether the petitioners had “reasonable cause” under section 6664(c)(1) for omitting $3.4 million of income from their joint 2006 Federal income tax return.

In 1998 the taxpayers participated in a financial transaction described as a “ten year total return limited partnership linked swap.” In entering into this transaction, the taxpayers were advised by an attorney who supervised the preparation of the tax return for the year at issue. The taxpayers provided to their tax return preparer 160-plus information returns, including the Form 1099-MISC reporting $3.4 million from the termination of the swap and Form 1099-INT reporting $60,291.69 of interest income from the swap.  The Form 1040 prepared for the taxpayers was 115 pages long. The return did report the $60,291.69 of interest income that the taxpayers received from the swap. Likewise, the return did not include the $3.4 million from the swap.

The IRS received a Form 1099-MISC reporting the $3.4 million for the swap, compared with taxpayers’ return, and determined a deficiency in tax of $521,473 and an accuracy related penalty under section 6662(a) of $104,295.  The taxpayers agreed to the assessment of tax in the amount determined by the IRS. As a result, their tax due, which they reported as $3,719,454, was actually $4,240,927.  The taxpayers paid the tax deficiency plus interest. However, the taxpayers petitioned the Tax Court disputing the accuracy-related penalty.

The Tax Court held that the taxpayers did not receive advice from tax professionals that would justify the omission of income.  In so holding, the Court held that because the taxpayers knew that their Form 1099 should have been included, they lacked reasonable cause for their return preparer’s failure to include the income.  The Court also held that the taxpayers failed to show that they were entitled to the “computational or transcription error” exception.  The Tax Court’s decision requires taxpayers to perform more than a cursory review of the return to ensure of its accuracy. 

The full decision can be found here.

The attorneys at Fuerst Ittleman, PL have extensive experience litigating tax issues against the U.S. Government.  You can reach an attorney by emailing us at:  contact@fidjlaw.com.

IRS Seeks to Reduce the Impact of Its Economic Substance Doctrine Field Directive by Stating it is Not Legal Precedent

On October 6, 2011, the Internal Revenue Service (IRS) announced that its July 15, 2011 field directive (the “directive”) pertaining to the codified economic substance doctrine (the “doctrine”) should not be viewed as legal precedent because the IRS reserves the ability to modify the directive at any time.

According to Mark Periwen, special counsel to the Associate Chief Counsel, the directive is “just that,” and therefore does not have the force of law.  Notably, the function of field directives issued to employees of the IRS is similar to the function of the Internal Revenue Manual (IRM), which directs IRS personnel in their day-to-day activities. Smith v. U.S., 478 F.2d 398 (5th Cir. 1973).  This does not follow, however, that field directives and the IRM will not be taken into consideration by reviewing courts.

Instead, as discussed in Griswold v. United States, 59 F.3d 1571, 1575 n. 8 (11th Cir. 1995), "[w]hile the IRS Manual does not have the force of law, the manual provisions do constitute persuasive authority as to the IRS’s interpretation of the statute and the regulations." (emphasis added).  Similarly, each field directive provides insight as to the IRS’s interpretation of the laws it is entrusted to enforce.

As we previously reported here, transactions shall be treated as having economic substance only if the transaction changes the taxpayer’s economic position in a meaningful way and the taxpayer has a substantial purpose for entering into the transaction. The doctrine only applies to a transaction entered into in connection with a trade or business or activity engaged in for income.

Taxpayers are concerned how the IRS will apply the doctrine due to the no-fault penalty of up to 40 percent. Tax practitioners speculate the issuance of the directive suggests the IRS wants to ensure that the doctrine is appropriately applied.  In fact, the directive specifically provides that agents should limit the assertion of penalties to transactions that implicate the doctrine and not a “similar rule of law” as provided in the statute.

The IRS’s original field directive regarding the application of IRC §7701(o) was issued on September 14, 2011 with the objective “to ensure consistent administration of the strict liability penalty related to the application of the doctrine.”  The July 15, 2011 field directive was issued to “instruct examiners and their managers how to determine when it is appropriate to seek the approval of the Director of Field Operations in order to raise the economic substance doctrine.”

As further elaborated in the directive:

Once an examiner determines that raising the doctrine may be appropriate, this directive sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

The directive, which is publicly available to all Taxpayers, clearly provides the IRS’s interpretation of IRC §7701(o).  Although it may not be binding as legal precedent, it is nonetheless highly persuasive and will not be ignored by courts that are deciding issues pertaining to the application of the doctrine.

Fuerst Ittleman will continue to monitor the progress of cases where the doctrine may be an issue. Our professionals at are knowledgeable in the newly codified economic substance doctrine. If you believe you have been affected by the new law, please contact our professionals at contact@fidjlaw.com.

Tax Court denies taxpayer’s attempt to recharacterize punitive damages as ordinary income

In Healthpoint Ltd. v. Comr., T.C. Memo 2011-241 (10/3/11), available here, the Tax Court held that a company could not rely on a settlement agreement to recast a jury award and settlement to avoid paying taxes at ordinary income rates.

The taxpayer filed suit against a rival company and received a jury verdict of $16.47 million, awarding actual damages ($5 million), punitive damages ($3,174,515), disgorgement of profit ($1,640,000), and Lanham Act enhanced damages ($6,349,030). While litigation was pending, the taxpayer filed suit against the same company on different grounds, however, both parties agreed to settle both law suits for $12 million and $4.5 million, respectively.

The parties allocated damages in the settlement agreement differently than the jury’s allocation.  In particular, the settlement agreement provided for no punitive damages, even though the jury had awarded punitive damages in the first suit.  As a result, the taxpayer reported $14.5 million in long-term capital gain and $1.8 million in ordinary income. The IRS conceded that the Lanham Act enhanced damages, which totaled $6,349,030 for loss of goodwill, are taxable as long-term capital gain. However, the IRS challenged the remaining allocations in the settlement agreement.

The Tax Court held that damages were not to be allocated in accordance with the parties settlement agreement but, rather, in accordance with the jury verdict in the first law suit.  The Tax Court determined that proceeds of a settlement agreement attributable to goodwill or damage to reputation are taxable as capital gains, but those determined to be lost or disgorged profits and/or punitive damages are taxable as ordinary income.   The court stated that normally express allocations in settlement agreements will be followed in determining tax consequences.  However, there is an exception if the settlement agreement is not entered into in an adversarial context, at arm’s length, or not in good faith.

The Tax Court ultimately held that damages should be allocated in accordance with the jury verdict because the verdict accurately reflected the economic realities versus the settlement agreement.

The attorneys at Fuerst Ittleman, PL have extensive experience structuring settlement agreements and litigating against the IRS in the event that a settlement agreement is not respected.  If you can contact an attorney by emailing us at: contact@fidjlaw.com.

U.S. District Court Disallows $82 Million Refund Claim as Transaction was Tax Shelter

In WFC Holdings Corp. v. U.S., No. 0:07-cv-03320 (D. Minn. 9/30/11) a refund claim based on capital loss deduction was disallowed because the underlying transaction was a tax shelter with no business purpose other than tax avoidance.

In the matter before the District Court, the taxpayer was the parent corporation of an affiliated group of corporations.   After a series of acquisitions, the taxpayer was left with a large quantity of excess leased space that it no longer needed, but which it was liable for (“underwater”).

KPMG marketed a tax product to clients called an “economic liability transaction.” The “economic liability transaction” involved a transfer of the “underwater” leases and a related stock sale to an investment bank. The taxpayer agreed to pay for KPMGs work on the “economic liability transaction.”  KPMGs employees developed the “economic liability transaction” with the understanding that a taxpayer needs a non-tax business purpose to justify the transaction.

The district court held that the transfer of “underwater” leases to a subsidiary and a related sale of stock was a sham tax shelter that the taxpayer had purchased from KPMG.  The court considered the lease restructuring transaction and, viewing the transaction as a whole, determined that the taxpayer had failed to establish a legitimate business purpose for the transaction other than tax benefits. The court concluded that the stock sale lacked economic substance and, moreover, did not accomplish the stated goal. The court stated that the lease restructuring transaction was designed, marketed, and implemented as a tax shelter, and the taxpayers actions indicated an absence of any real potential.

A full version of the opinion is available here.

The attorneys at Fuerst Ittleman, PL have extensive experience litigating against the IRS and the Department of Justice “ Tax Division regarding tax shelters and transactions the IRS considers to lack business purpose. You can contact an attorney by emailing us at: contact@fidjlaw.com.

Fifth Circuit Court of Appeals affirms District Court’s determination that Partnership Was a Sham

Fifth Circuit Court of Appeals affirms District Courts determination that Partnership Was a Sham

In Southgate Master Fund LLC v. U.S., No. 09-11166 (5th Cir. 9/30/11), the Court held that the loss claimed by the deducting partner was properly disallowed because the partnership was a sham.

The facts of the case are complex.  A Chinese-government-owned financial institution formed a single-member limited liability company (SMLLC).   As a wholly owned subsidiary, the SMLLC was created for the purpose of acting as its parents U.S. investment vehicle for nonperforming loans (NPLs) transactions. The parent company contributed to the SMLLC  a portfolio of NPLs.  The parent company contributed the NPLs to the SMLLC pursuant to a contribution which contained a series of warranties and representations stating that the parent company had not written off, compromised, or made a determination of worthlessness as to any of the NPLs.

The SMLLC and a related party formed and organized an S-corp.  Upon formation, the SMLLC contributed the NPLs to the S-corp. pursuant to a virtually identical contribution agreement. In exchange, the SMLLC received a 99% ownership interest in the S-corp.  The related party contributed cash and a promissory note in exchange for a 1% ownership interest in the S-corp. The related party was appointed as the S-corp.s sole manager.

After receiving due diligence reports that the loans were valid and worth between $44.67 million (3.9% of face value) and $111.8 million (9.76% of face value), the taxpayer agreed to purchase a portion of the Chinese parent company and the SMLLCs interest in the S-corp.

The taxpayer formed its own single-member LLC, (TSMLLC), through which he would invest in the S-corp. The taxpayer executed a series of transactions which resulted in the taxpayer becoming a direct 89.1% owner of the S-corp. The taxpayer then took the position that the series of transactions had increased his outside basis in the S-corp. by $180.6 million. The taxpayer ultimately took a $210.5 million deduction on his tax return because of losses from the NPLs.

The IRS issued a final partnership administrative adjustment (FPAA) pertaining to its partnership return. The partnership filed a petition for review in federal district court. The district court upheld the FPAA’s disallowance of the claimed losses on the ground that the partnership was a sham for tax purposes. However, the district court disallowed the imposition of penalties on the ground that the partnership had established reasonable cause and good faith and thus had a complete defense to any accuracy-related penalties. Both parties appealed the adverse determinations.

The Fifth Circuit held that the partnership was a sham, the deduction should be disallowed, and disallowed the accuracy-related penalties.  The Fifth Circuit applied a totality-of-the-facts-and-circumstances test to determine whether the partnership was a sham. Ultimately the Court determined that the partnership was “a meaningless and unnecessary incident” inserted into the chain of entities, transactions, and agreements through which the NPL acquisition took place. The partnership served no legitimate purpose whose accomplishment was not already assured by other means or could not have been equally well assured by alternative, less tax-beneficial means.  The full text of the opinion can be found here.

Second DCA Asks Florida Supreme Court To Rule On Drug Statute’s Constitutionality

On September 28, 2011, Floridas Second District Court of Appeal (“2nd DCA”) asked the Florida Supreme Court to rule on the constitutionality of Floridas Drug Abuse Prevention and Control law, § 893.13 Fla. Stat. in the case of State v. Adkins. A copy of the 2nd DCAs opinion can be read here. As we previously reported, on July 27, 2011, Judge Mary Scriven of the United States District Court for the Middle District of Florida declared the law unconstitutional under the United States Constitution as a violation of due process because it eliminated mens rea as an element of felony delivery of a controlled substance thus making the law a strict liability offense.

The federal courts decision has opened the floodgates to litigation in pending drug cases in Florida and has led to uncertainty for criminal defendants for two main reasons. First, because the United States and Florida are separate sovereigns, the rulings of federal courts other than the U.S. Supreme Court are generally not binding on state courts. Second, because neither the Florida Supreme Court nor any District Court of Appeal has ruled on the constitutionality of § 893.13, the Circuit Courts of Florida (the tribunals responsible for adjudicating felony criminal cases) have no binding precedent to rely upon in determining whether § 893.13 is constitutional.

As a result, the Circuit Courts have split on the issue as to whether § 893.13 violates the 14th Amendment. In fact, as noted in the 2nd DCAs Certification Order, in certain circuits, such as the Eleventh Judicial Circuit in Miami-Dade County, conflict exists within the different felony divisions with some judges adopting Judge Scrivens opinion and declaring the statute unconstitutional while others finding the Middle District of Floridas rationale unpersuasive because the precedent relied upon by that court was distinguishable.

In certifying the question of whether § 893.13 is constitutional, the 2nd DCA stated that because it would be the only district court of appeals to have ruled on the constitutionality of the drug law, its “decision would be binding statewide and could affect literally thousands of past and present prosecutions throughout the state.” The 2nd DCA noted that while the Florida Supreme Court prefers to resolve cases after multiple district courts have issued opinions, given the volume of the cases involved and the fact that the issue has been “fully briefed and thoroughly discussed” in trial court proceedings, it would be appropriate for the Supreme Court to decide this issue.

Although the 2nd DCA certified the question to the Supreme Court as one of “great public importance” pursuant to Fla. R. App. P. 9.125, it should be noted that because the Florida Supreme Court is a court of limited jurisdiction, the Court can choose not to decide the issue under  Article V § 3 of the Florida Constitution as jurisdiction over such certified questions is not mandatory.

Fuerst Ittleman will continue to track the progress of this matter with a keen eye as its final resolution could affect all strict liability offenses. The white collar criminal defense lawyers at Fuerst Ittleman are experienced in handling even the most complex cases where clients are facing allegations of criminal actions. The attorneys of Fuerst Ittleman have defended clients in cases involving numerous general intent and strict liability offenses including money laundering violations found at 18 U.S.C. § 1957, the operation of unlicensed money transmitting businesses found at 18 U.S.C. § 1960, and violations of the FDCA under 21 U.S.C. §§ 331 and 333 as well as prosecutions of corporate officials for FDCA violations under the Park Doctrine. For more information regarding Fuerst Ittlemans white collar criminal defense practice, contact an attorney today at contact@fidjlaw.com.