Supreme Court Has Taken Ammunition From IRS In Son Of Boss Cases - Time To Fix Bayonets ?

Originally Published on forbes.com on April 6th,2012

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Just so the lawyers do not think I am a moron, I suppose I should talk about what is good about the Supreme Court’sdecision in the Home Concrete case. Normally the IRS has three years to audit you after you have filed your return. If you “forget” to report a significant percentage of your gross income (25%), they get an extra three years. I think the idea is that it is easier to spot phony deductions than missing income.

When you sell something your income is only the gain from what you sold. So what happens if instead of “forgetting” to report the sale you “make a mistake” about your basis ? The IRS argued that they had six years in that case also. They issued a regulation to that effect and applied the regulation retroactively. There were numerous circuit and Tax Court decisions that either invalidated the regulation, said it could not be applied retroactively, was just fine and could be applied retroactively and I think there was one that said it wasn’t even needed, but I have not gone back and reviewed them all.

The Supreme Court said that they answered the question in 1958 and even though the language in the 1954 Code was a little different than the 1939 Code, that their decision was based on, the answer was the same. An overstatement of basis is not an omission from income. I like that clarity.  There is a lot more lawyerly procedural stuff in the decision and it is a 5/4 decision with Antonin Scalia writing his own opinion because he thinks the four he voted with were right for the wrong reasons.  So the lawyers willhave a lot of fun with it.

I did not like the decision, because it lets the clients of the Big Four get away with murder.  The taxpayers affected by these cases did not “make a mistake” about their basis. They hired Big Four firms to create basis out of thin air. What is particularly egrigous about the schemes is that they were based on one sided entries.  I called it “Debit by the Window – Credit out the Window“.  Richard Egan’s attorney talked about how some schemes used basis rather than creating losses, which was less likely to be noticed by the IRS.  If the price of EMC stock had not collapsed, there would have been no big ugly negative numbers on his return, just lower gains.  No tax shelter here – just a hard working high tech billionaire paying more taxes than most people.  So we have the Supreme Court blessing people who did a better job gaming the system than KPMG and McGladrey did for Mr. Egan, who was caught before three years were up.

Robert McKenzie commented extensively on my first piece on the casestarting out quite diplomatically by observing “Peter misses the point of the ruling”.  He actually did have a good point (which I had not missed):

It should also be noted that had the IRS prevailed in this case it would been allowed to audit most capital transactions for 6 years not 3. Every person who sold a rental property or a significant amount of stock would have been subject to an IRS financial proctolgy exam for up to 6 years. If Congress dislikes the results the results of this case it can amend the law but in so doing it will subject many of the 99% who lack to the resources to hire talented tax lawyers to IRS intrusion into their finances for more than 3 years. In my 40 years as a tax lawyer there is one certainty, every time Congress grants the IRS more power some of its agents will abuse that power.

Actually it would be not most capital transactions.  It would be large, relative to gross income, capital transactions where there was significant reported basis relative to proceeds.  At any rate if the IRS had prevailed it would have been worrisome for people who were not trying to get away with anything.  Three years should really be enough for somebody who is confused about their basis in all those AT&T subsidiaries or had to reconstruct the record on improvements they made to a vacation home they sold.

Robert Wood in his piece noted:

Robert McKenzie, tax lawyer with Chicago’s Arnstein & Lehr LLP said four clients of his firm with similar issues would likely reap tax savings approaching $40 million. Indeed, some reports say the case calls into question up to $1 billion in tax revenues. The IRS was hoping to collect this huge amount in about 30 related cases involving “Son of Boss” tax shelters.

Mr. McKenzie’s clients were probably people who got confused about their basis in AT&T stock or sold vacation homes and had to estimate how much they had put in improvements not people who had collectively reaped $200,000,ooo in capital gains and hired the Big Four to rig up transactions that would fly below the radar and allow them to pay nothing – except big fees.  If they were my clients, I would be glad about it too.  In a little e-mail exchange about the case he noted “Everybody benefits when the courts restrain the IRS from making its own rules.”    I don’t know about everybody, but it is true you do have these situations where basis documentation is on the sketchy side and it is comforting to know that you can rest easy after three years.

There is still that billion dollars though.  Does the IRS have to retreat from trying to fix what Jack Townsend calls a “raid on the fisc” now that the Supreme Court has taken away their ammunition?  It almost feels like Joshua Chamberlain on Little Round Top:

Jack questions why the IRS bothered trying to extend the scope of the six year statute to apply to these cases, when they had, and in some of the cases may still have, another weapon available – an unlimited statute for fraud:

But there is a glaring candidate for the presence of fraud in these cases.  In most, if not all, a condition of the hokey but foggy tax opinions that were rendered was that the taxpayer personally represent to the opinion writerthat the taxpayer had a profit motive apart from the tax benefits for entering the transaction(s) which generated the imagined tax benefits.  In truth, there was little economic substance in these deals and the taxpayer was really motivated by the hokey tax savings.  So, the taxpayer was not really telling the truth in many — probably most, if not all — of these shelters when the taxpayer made that representation about his or her profit motive.  Without that untruth, the hokey tax opinion would not have been uttered and the hokey shelter claims would not have been made and the fisc would not have been raided.  So the question has to be asked why the IRS did not pursue civil fraud in at least some of these cases — to get the unlimited statute and a civil penalty more fitting to the egregious conduct being punished.

Would using the unlimited statute for fraud give the Service the advantage of moving down the hill ? It might, because instead of a 40% penalty, there is a 75% penalty.  As I have often, said I usually root for the taxpayers, but this one is an exception.  I really hope that the Son of Boss swat team has just heard somebody say “Fix Bayonets” and that all winning this case had done for the Son of Boss guys is add another 35% to the penalty.

You can follow me on twitter @peterreillycpa.