Richard Egan Estate Subject to 40% Penalty on Doomed Shelter

Originally Published on forbes.com on October 28th,2011

______________________________________

I thought I was done with Fidelity International Currency Advisors back in January when I wrote the fourth post in what I call my EMC trilogy. Last December,the legal team defending EMC founder Richard Egan’s ill fated tax shelter pulled out a small victory after having lost spectacularly.  Of the $220,944.65 in litigation expenses that the feds sought to charge them with $65,896.10 was disallowed.  It was not much of a victory particularly when weighed against $80,000,000 in tax and penalty.  Perhaps emboldened by the small win, they went hunting for bigger game.  They were trying to get the penalty cut in half.  The decision, another loss for team Egan, is a good read.  It lays out the original plan in all its absurdity in a very clear manner:

To this end, in July 2000 Egan formed Fidelity asa limited liability company federally taxed as a partnership. Egan was one partner; the other principal partner was Samuel Mahoney, who was an Irish citizen. Common shares were initially assigned 93 percent to Mahoney and 5 percent to Egan; Egan contributed $2.7 million in cash and certain interest rate options valued at $1.6 million, and Mahoney contributed $651,000 in cash. 

Then, in October 2001, Fidelity entered into a set of transactions whereby it purchased and sold options, related to foreign currency exchange rates and configured in pairs: the terms set for each pair (as to premium, strike price, maturity dates, and possible payout) assured that a loss on one option in a pair would be offset by a corresponding gain on the other. In substance, the transaction would provide virtually no opportunity for a net gain but also no risk of a net loss.  

One week later, Fidelity terminated four of the options that had gained in value due to fluctuations in the currency exchange rates. The offsetting options in the pairs, correspondingly reduced in value, were not terminated. Instead, the proceeds from the terminated options were used to purchase replacement options that would ensure that the eventual losses taken by the partnership when it terminated the original options that had lost value and the replacement options would offset the gains initially realized. 

This generated net taxable gains on Fidelity’s books of about $174 million from the options that had been terminated. But under the tax laws Fidelity pays no taxes; rather its gains and losses are assigned to the partners in accordance with their ownership shares in the partnership and taxed to the partners on their own returns. 26 U.S.C. §§ 701–702 (2006). Because of the then-existing 5 and 93 percent share allocation, Egan was assigned $7.1 million net gain and Mahoney $163.3 million net gain.

Then, a week later, in early November 2001, Egan bought 88 percent of the common partnership interest from Mahoney for $325,500 and so owned 93 percent with Mahoney being reduced to 5 percent. A month later, in early December, Fidelity terminated the four remaining original foreign currency options as well as the replacement options acquired immediately after the October termination. Not surprisingly in light of thedesign of the option pairs, the December loss ($178.1 million) only modestly exceeded the original gain.

Fidelity now allocated the $178.1 million loss in proportion to the reallocated ownership shares: Egan was allocated $165.8 million in loss and Mahoney $8.8 million. The net economic loss to the partnership from all the offsetting foreign currency options was just over half a million dollars; advisory fees brought the total cost to $4.1 million–a cost dwarfed by the potential tax benefits for Egan.

 So Egan and Mahoney were partners.  The partnership had unrecognized gains and unrecognized losses.  The partnership recognized gains that were allocated mostly to Mahoney.  Ownership was switched and it recognized losses that were mostly allocated to Egan.  Richard Egan did not get to be a billionaire by doing deals like that.  And people got paid 4.1 million for this bullshit.  That is what they called value billing.  The Egans could not get brilliant ideas like this from the regional firm that had been serving their family.  They hired an attorney, Stephanie Denby to search out the best deal being offered by the sophisticated national firms, finally settling on KPMG.  She or her firm must have been on an hourly basis as their was a bit of envy in her comments to the CFO of the family office:

On May 26, 2000, Denby sent Reiss an e-mail regarding the previous day’s meeting and her discussions with Helios after the meeting concerning fees: 

… after the meeting I discussed with Helios the fees. The fees are based on a 3% rate. If KPMG were not involved Helios would just pocket a larger percentage. Since our connection came from KPMG, Helios would pay them a referral fee anyway. I think at the same rate. So [their] involvement does not cost more but just results in reallocation of the base fee. I know from other situations this reallocation occurs simply from [our] getting the name [from] KPMG. We are in the wrong business!

Regardless, finding an accommodating Irishman to pick up income so you could take losses was not all that was involved in this plan.  The loss allocations would do Mr. Egan no good if he did not have basis to absorb the loss.  To accountants this is an insurmountable problem.  Not so to tax attorneys.  I explain how they manufacture basis out of thin air in this post.  It pains me to repeat it.  You may have heard the old accounting joke “Debit by the window – credit by the door”.  Well that accountant went to law school and got an LLM in taxation and spent too much time looking at Code Section 752 and converted to “Debit by the window – credit out the window”.

At any rate the bullshit was declared bullshit by the First Circuit in May of 2010.  They held off on the applicability of penalties until the fall when they amended the decision to drop this other shoe:

(6.) The following accuracy-related penalties are applicable to any understatement of the income tax liability of Richard Egan arising from the treatment of the Fidelity High Tech and Fidelity International transactions on the tax returns of those entities for the years 2001 and 2002. 
(a.) a 40% penalty for gross valuation misstatement pursuant to § 6662(a), (b)(3), and (h); 
(b.) a 20% penalty for substantial valuation misstatement pursuant to § 6662(a) and (b)(3); 
(c.) a 20% penalty for substantial understatement of income tax pursuant to § 6662(a), (b)(2), and (d)(2)(A); and 
(d.) a 20% penalty for negligence or disregard of rules and regulations pursuant to § 6662(a) and (b)(1).

So what is the latest argument ?  As you can see from the above the deal stinks four different ways.  The penalties are not cumulative though.  Guess which one the IRS is picking to apply ? That is right - the 40% penalty behind door (a).  That is the basis bullshit.  The Egan lawyers are arguing that since the IRS could blow up the deal in other ways, the basis bullshit is irrelevant.  The Court did not buy their argument (which is of course more sophisticated than my restatement):

Indeed, one might think that it would be perverse to allow the taxpayer to avoid a penalty otherwise applicable to his conduct on the ground that the taxpayer had also engaged in additional violations that would support disallowance of the claimed losses.

When the first decision came out in May of 2010, there was some vilification of Richard Egan, which I believe was undeserved.  Mr. Egan helped put men on the moon and built a great company in EMC.  The one time he appears in the decision he is heard to comment that he wished his advisers would pay more attention to making him money rather than saving money.  In business culture, it is considered irresponsible to overpay taxes.  How do you tell you are not overpaying ?  You consult the experts at the most prestigious law and accounting firms. I think what happened was that those experts became consumed with envy. You can make good money doing high level tax work, but you will almost always be working for people who are richer than you are.  Mr. Egan grew up in Dorchester and became ambassador to Ireland.  I can think of few things more gratifying than that.  I suspect his final years would have been happier if he had just paid the taxes when he cashed in his EMC options, but I hope they were not blighted too much by this nonsense.