11   The Government Closes In

When the Internal Revenue Service announced in December 2001 that taxpayers who had engaged in questionable shelters could escape penalties if they disclosed their participation to the agency by the following April, Representative Lloyd Doggett (D, Texas) criticized the IRS action as “all carrot and no stick.”¹ The stick was soon to come in the form of IRS enforcement actions against major accounting firms, law firms, and advisory boutiques to require them to disclose the identity of taxpayers who had participated in shelters, soon to be followed by Congressional hearings, criminal investigations, and prosecutions.

The Summons Weapon

By spring 2002, the IRS had summonses outstanding to accounting firms KPMG, Ernst & Young (E&Y), Arthur Andersen, PricewaterhouseCoopers (PwC), and BDO Seidman, as well as to several law firms and investment advisors. By law, the agency is authorized to issue a summons to obtain information relevant to ascertaining the accuracy of tax returns and determining the liability of any persons in connection with their obligation to file returns and pay federal taxes.² The IRS may also issue a summons for the purpose of “inquiring into any offense in connection with the administration or enforcement of the internal revenue laws.”³ The first firm to exit the shelter market, PwC, reached an agreement with the IRS in June 2002 to resolve the agency’s investigation of the firm’s tax shelter activities. Under the settlement PwC agreed to pay $10 million to the agency and to cease marketing abusive tax shelters.⁴

The summons directed at E&Y sought information about compliance with registration requirements in connection with COBRA transactions. After receiving the summons in April, the firm concluded that identities of taxpayers were not privileged because the information was disclosed in their tax returns, which reflected their claimed losses as a result of participating in the shelter transactions. The accounting firm notified its clients of its decision.

Among those clients were Henry Camferdam and three colleagues who had participated in the COBRA shelter described in chapter 6 to wipe out a tax liability of more than $70 million. When they received the notice, Camferdam and his colleagues informed E&Y that they objected to the disclosure of any information, including their names and documents. The next day, Jenkens & Gilchrist instructed the accounting firm, on behalf of clients who had participated in the COBRA transactions, not to disclose information or documents related to them.

When E&Y responded that, on advice of its law firm, it planned to identify clients who had engaged in the transactions, the former clients sued, seeking a temporary restraining order to prevent any disclosures. After the district court denied the request for a restraining order in early fall, E&Y disclosed the names of the investors to the IRS. After the firm complied with the IRS summonses, the agency began interviewing E&Y personnel about the firm’s shelter activities.

That same spring, the IRS issued nineteen summonses to Arthur Andersen relating to potentially abusive tax shelter transactions involving at least forty-eight different investors.⁵ The agency estimated that improper tax deductions in each transactions ranged from at least $10 million to as much as $1.6 billion. In response to the summons, Arthur Andersen initially played hardball. After the IRS petitioned a court to enforce the summonses,⁶ the firm entered into an agreement to produce the information the agency was seeking and notified former clients that it would be handing over their names to the IRS. Like E&Y’s former clients, the clients who purchased shelter transactions from Andersen tried to prevent disclosure, arguing that their identities were protected by the statutory tax practitioner-client privilege.⁷

The government also sought information from BDO Seidman. In April and May 2002, IRS Revenue Agent Michael Friedman met with the firm’s counsel. In those meetings, BDO claimed that it had not promoted any potentially abusive tax shelters and therefore could not be subject to any penalties under the registration and list maintenance requirements. The firm also refused to acknowledge the existence of its Tax Solutions Group. On May 2, Friedman issued summonses to BDO requesting documents relating to twenty potentially abusive shelter transactions. BDO responded by asserting that it had no responsive documents and, even if it did, those documents were privileged under the statutory tax accountant-client privilege.

In July, the Justice Department filed suit in federal district court in Chicago to enforce the summonses against BDO. In support of its actions, the Department made available hundreds of pages of documentation, which provided detailed descriptions of how a previously well-respected accounting firm had engaged in systematic efforts to design and market tax shelters. Among other documents, the enforcement petition contained a list of individual BDO offices’ contributions to the generation of over $100 million in Tax Solutions Group revenues for fiscal year 2000, ending on June 30, 2000.⁸

Later in 2002, Camferdam and other COBRA purchasers were notified that the IRS would be auditing their tax returns for 1999 and that the agency would not recognize losses resulting from COBRA transactions. On December 20, 2002, Camferdam and fellow investors filed suit in federal court in New York against several defendants, among them E&Y, Jenkens & Gilchrist, and Paul Daugerdas, contending that the defendants “knew or should have known” that COBRA was “an illegitimate tax sham.”⁹ The suit sought more than $40 million in compensatory damages and $1 billion in punitive damages. Eventually, it was consolidated with a class action suit in which Thomas Denney, another tax shelter purchaser, was the lead plaintiff. The consolidated action would come to include another group of investors and eventually encompass 1,100 class members who had obtained opinions from the firm on COBRA, PICO, and other shelters.

The IRS’s enforcement actions gained momentum as more and more reports were appearing in the news that wealthy individuals were using tax shelters, purchased from major accounting firms, to avoid paying taxes. In early 2003, telecommunications giant Sprint—beleaguered due to its ties to scandal-ridden WorldCom—announced that it had terminated its top two executives without severance pay when it discovered that they had purchased tax shelters from E&Y, the company’s auditor. The shelters allowed the executives to indefinitely defer taxes when they exercised stock options, which resulted in excess of $300 million in profits. According to some estimates, had the executives not participated in the shelter, they would have owed more than $123 million in taxes.¹⁰

Although Sprint did not explain its decision, the sale of risky tax strategies to the company’s CEO and president compromised E&Y’s capacity to function as an independent auditor. Sprint subsequently changed auditors—to KPMG—and adopted a policy that prohibited its auditing firm from offering tax advice to company executives. Soon other stories appeared describing how other executives at Sprint had participated in the same shelter and how executives at other companies, including Dennis Kozlowski, the disgraced CEO of Tyco, had purchased similar shelters from Arthur Andersen.

Outrage at the spread of tax shelters among the very wealthy soon spread beyond the business press. In a 2003 editorial, the New York Times denounced the “unbridled greed” that had led the executives to award themselves the options and then try to avoid the taxes after exercising them. The Times also faulted E&Y, declaring, “Auditors should be protecting shareholders, not peddling tax schemes to the companies they audit, or their officers.” Tying the Sprint controversy to the Enron debacle, the editorial noted that the company had managed to avoid paying any taxes to the IRS between 1996 and 1999 on reported profits of $2 billion. The editorial linked these activities to a large tax shelter industry driven by major professional firms. “Enron may be gone,” the Times said, “but many of those who were complicitous in its tax shenanigans—the prestigious law firms, investment banks and accounting firms—are still making big money instructing companies on how to beat the taxman.”¹¹ As it happened, the lead developer of Enron’s shelters was Bankers Trust, which was subsequently sold to Deutsche Bank, the most active financial institution in the individual shelter market.¹²

In late February after three years of comments, the Treasury Department issued final regulations governing taxpayer disclosure, promoter registration, and promoter list maintenance in connection with potentially abusive transactions. The regulations sought to identify straightforward categories of suspect strategies so they would easily come to the IRS’s attention without deluging the agency with disclosures involving legitimate tax-favored transactions. Among the categories that the regulations identified were transactions offered under conditions of confidentiality, those that had been listed by the IRS, and those that generated significant losses and included losses claimed by individuals, S corporations, trusts, and partnerships involving individuals.¹³

The following month, IRS Chief Counsel B. John Williams reported on the agency’s continuing pursuit of abusive shelter promoters. Based on an examination of seventy-eight entities such as law firms, accounting firms, and investment banks, Williams announced that there had been a “wholesale failure to comply with registration requirements.”¹⁴ Five cases involving seventy-six summonses had been referred to the Justice Department for enforcement, and he suggested that there would be more. Turning to the taxpayer settlement offers, Williams announced that although the response to the contingent liability shelter initiative was still not known, 92 percent of the 488 taxpayers known to have been involved in basis-shifting shelters had accepted the settlement terms. The IRS subsequently reported that about half of the 126 known participants in contingent liability shelters had applied for settlement.¹⁵

The enforcement actions against Arthur Andersen and BDO, however, had become mired in questions of privilege. Trial courts in those cases had recognized limited protection for client identities under the statutory taxpayer privilege and were attempting to sort out what standards applied. By the spring of 2003, the issue was pending in the Court of Appeals for the Seventh Circuit, which observers hoped would clarify whether—and, if so, under what circumstances—taxpayers could prevent accounting firms from disclosing their names to the IRS.

A New Team at the IRS

On May 1, 2003, the Senate confirmed Mark Everson to succeed Charles Rossotti as IRS Commissioner. Everson had served as the Deputy Director for Management at the Office of Management and Budget after working as a finance executive at two global companies. Earlier in his career, he had served in the Reagan administration as special assistant to Attorney General Edwin Meese and as deputy commissioner of the Immigration and Naturalization Service. During his confirmation hearings, Everson assured the Senate Finance Committee that “enforcement will be a principal responsibility of the IRS.”¹⁶ Soon after his confirmation, Everson reported at a House Appropriations panel hearing on IRS compliance efforts that the agency had 372 civil and 464 criminal promoter investigations ongoing.¹⁷ In May, the IRS had also estimated that the disclosures under the initiative that ended on April 23, 2002, had provided information on shelters involving more than $30 billion in claimed tax losses or deductions.

Within a few months of Everson’s confirmation, Mark Matthews returned to the agency as the new Deputy Commissioner for Services and Enforcement, a position Everson created as part of a realignment of the IRS’s management structure.¹⁸ Matthews, a former prosecutor, had been head of the IRS Criminal Investigation Division (CID) from 2000 until he left in May 2002 to serve as the global co-head of Deutsche Bank’s anti-money-laundering compliance program.¹⁹ A year later, he was back. By recruiting Matthews for a new high-level enforcement position, Everson underscored that bringing criminal actions for participation in abusive tax shelter promotion was a top priority. He reinforced the message that the IRS was committed to combating abusive shelters by hiring John Klotsche, a tax lawyer and former chair of Baker & McKenzie, as a senior advisor to coordinate the efforts against shelters and to oversee enforcement more generally.

By summer, the IRS’s enforcement actions against accounting firms were gaining momentum. The IRS investigation of E&Y’s failure to register its shelters eventually ended in a settlement between the agency and the firm in July 2003. Under the agreement, the firm would pay a $15 million penalty and agree to ongoing IRS review of its compliance policies. IRS Commissioner Everson was delighted: “We are pleased that Ernst & Young has cooperated fully with the IRS in resolving these matters. In particular, the ability of the IRS to review the firm’s compliance on an ongoing basis will help to reduce the likelihood of future violations of the registration and list maintenance requirements. This represents a real breakthrough and is a good working model for agreements with practitioners.”²⁰ All clients who had purchased CDS, COBRA, CDS-Add On, and PICO were ultimately audited, and many ended up paying back taxes, interest, and often penalties.

Later that summer, the Justice Department enjoyed another major victory. In a case involving summonses issued to BDO Seidman, the Seventh Circuit held that the IRS list maintenance requirements defeated any claim that taxpayers could reasonably expect that information about them would be kept confidential. The court further held that the tax accountant privilege did not encompass communications occurring for the purpose of preparing a tax return.²¹ The court’s ruling put to rest the issue of whether former clients who had purchased a shelter could prevent disclosure of their names to the IRS.²² Based on the Seventh Circuit’s decision, the court in the enforcement action against Arthur Andersen ruled that investors in shelters promoted by Andersen could not prevent disclosure of their identities to the government.²³ In the fall, the IRS forged ahead against another accounting firm, issuing summonses to Grant Thornton.²⁴

Continuing to exert pressure on accounting firms that had participated in the shelter market, the IRS moved in late September 2003 to enforce nineteen summonses for documents that it had issued to Arthur Andersen.²⁵ The agency described a series of requests for information about shelter activity to which Andersen had been unresponsive dating back to December 2000. According to the IRS, at least forty-eight different investors had participated in potentially abusive shelter transactions promoted by Andersen, none of which the accounting firm had registered. The IRS estimated that “the amount of likely improper tax deductions in these transactions ranges from at least $10 million to as much as $1.6 billion.” Former clients again moved to intervene, arguing that their identities were protected by privilege.

At BDO, meanwhile, government pressure was mounting, and the board decided to clean house. In fall 2003 it removed Denis Field as CEO and board chair and Charles Bee as vice chair, placing them on indefinite leave.

Around the same time, the IRS announced that it was examining the activities of thirty promoters. In addition, it reported that over 1,200 taxpayers had disclosed questionable transactions in response to the amnesty that had ended in late April. Using information obtained from the disclosure initiative to identify specific types of shelters, the IRS offered settlements to taxpayers who had engaged in “basis shifting” shelters, like FLIP and OPIS, and contingency liability shelters, like BLIPS and COBRA. The government’s two-pronged approach—encouraging taxpayers to come forward while requiring promoters to disclose clients’ identities—was beginning to bear fruit.

Summoning Sidley Austin

Under the IRS amnesty offer that concluded in April 2002, some eighty taxpayers had disclosed participation in shelters that the law firm Sidley Austin Brown & Wood had promoted, solicited, or recommended. The vast majority of these were executed at Brown & Wood before it merged with Sidley & Austin in April 2001. On the basis of this information, the IRS petitioned the federal district court in Chicago on October 14, 2003, for authority to issue a John Doe summons to the firm. A John Doe summons, which requires judicial approval, is a request to a third party for the names of taxpayers whose identities currently are unknown to the IRS. If there are objections to a John Doe summons, the statute of limitations for assessing tax deficiencies for investors is automatically stayed beginning six months after the service of the summons. The summons sought the identities of other taxpayers who had been involved in shelters in which the firm had participated from January 1, 1996, through the date of the petition. According to the petition, the IRS had learned that during this period Sidley had organized or sold potentially abusive tax shelters, or both, including those that were the same as or similar to various listed abusive transactions. The court granted the petition the following day. Sidley responded by providing the identities of some taxpayers covered by the summons, but withheld the names of more than 370 shelter participants on the grounds that they had not consented to disclosure.

In the midst of this controversy, Sidley learned that R. J. Ruble had a personal arrangement to receive 20 percent of the revenues from Chenery Associates’ sale of the CARDS shelter. On October 27, 2003, the firm expelled Ruble from the partnership “for breaches of fiduciary duty and violations of the partnership agreement.”²⁶ The announcement of the expulsion concluded by saying that “pursuant to our firm policy, we will not comment further on personnel matters.” To avoid having the expulsion used against it as an admission that it had been involved in tax shelters, the firm took pains to explain that the expulsion “in no way relates to the substance of opinions at issue in current litigation or to any ongoing tax work for existing clients.”²⁷

On November 20, 2003, Ruble and former Brown & Wood managing partner Thomas Smith, who was now with the merged firm, appeared before the Senate Permanent Subcommittee on Investigations (PSI). This was the second day of hearings before the Subcommittee on the role of accountants, lawyers, and financial professionals in the U.S. tax shelter industry. The hearings were the culmination of an extensive investigation initiated in 2002 by the then-chair of the PSI, Carl Levin (D, Michigan). Accompanied by his lawyer, Ruble declined to testify, asserting his constitutional right not to incriminate himself.²⁸

Smith followed with a prepared statement in which he sought to distance the firm from Ruble’s tax shelter work. According to Smith, Ruble had been expelled from the firm for “accepting undisclosed compensation and for refusing to explain his conduct to the firm.” Of the ten tax partners at Brown & Wood before the merger, he noted, Ruble was the only one who engaged in tax shelter practice “although he consulted with others on discrete issues.” Smith explained that the firm had an opinion committee that partners were expected to consult on novel legal issues and that the firm required the approval of tax opinions by a second partner. Smith maintained, however, that “[n]o set of procedures will stop an individual from acting improperly if he or she is unwilling to abide by the rules of our profession and to engage in blatant acts of deceit and concealment.” Ruble, Smith said, “evaded our controls we had in place and he breached the trust we reposed in him.”²⁹

Senator Norm Coleman (R, Minnesota) pressed Smith during the question period about Ruble’s email to KPMG partners indicating that Smith had approved an alliance with KPMG. Flushed and somewhat agitated, Smith sputtered: “[L]et me just caution, I am sure you can tell . . . I am very outraged.” He continued, “The first I knew about that email was when I read it in the Wall Street Journal several weeks ago. I knew nothing about that. We had never been told that there was any sort of an alliance or proposed alliance with KPMG or anyone else.” “I take it [Ruble was] not operating by himself?” Coleman asked. Smith responded, “Well, that is a good question. We have all of this under review. I think in large measure, what we fear most in a law firm, he was a lone wolf . . . not to mention a rogue partner, which is your greatest fear.”³⁰

In response to a question about the scope of Sidley’s participation in KPMG transactions, Smith said the firm’s understanding was that Ruble was “not involved in the design of these products, but that KPMG would come to him with the product and ask him if he could render the concurring opinion.” Smith added that Ruble “would perhaps make suggestions so that he could render his opinion and perhaps he might—I guess if he saw something there to improve the product, he might have passed that on.”³¹

Senator Levin was even more forceful in his questioning. He asked how the firm could justify billing clients $50,000 for “cookie-cutter” opinions and why no one at the firm asked Ruble if he had some kind of arrangement with KPMG. Smith‘s understanding was that KPMG would give clients a choice of two or three law firms they could use and that Ruble played no role in marketing or promoting the shelters. Levin also questioned whether any meetings had actually occurred with clients before the firm provided them with opinion letters. When Smith acknowledged that he did not know, Levin asked, “Is it possible that in most cases, there were no client consultations, you simply submitted the letter?” Smith said that he had never asked Ruble that question, but he assumed that “[t]he tax partners would have.” When Levin inquired whether Smith had asked the tax partners if Ruble had any contact with clients, he acknowledged that he had not. Levin also continued to press Smith about the failure of anyone at the firm to inquire about the arrangements between KPMG and Ruble.³²

Sidley later filed responses to supplemental questions from the Senate Permanent Subcommittee on Investigations, clarifying that Ruble’s opinion letters had not been reviewed by other tax lawyers at the firm.³³ In a letter submitted on behalf of the firm, Smith explained that it was his understanding “that none of the partners in the tax department considered themselves to have functioned as a reviewing partner or ‘second signer’ on any opinion Mr. Ruble issued in the KPMG transactions.” Smith noted that “[t]o the extent Mr. Ruble did not observe the practices, procedures, or requirements of the firm with respect to review of opinions issued by Mr. Ruble in the KPMG transactions, [he did] not know why Mr. Ruble” did not do so.³⁴

One month later, the Justice Department petitioned the federal district court in Chicago to enforce the summons against Sidley. The petition included declarations from two IRS agents that elaborated on the government’s information about the firm’s involvement in tax shelter activities.³⁵ Sidley eventually disclosed the names of several hundred former shelter clients, but withheld the names of forty who objected to disclosure. After allowing these forty anonymous former clients of Sidley to intervene in the proceeding, the court granted the government’s motion to enforce the summons on April 28, 2004.³⁶

Targeting Tax Professionals

On December 29, 2003, the IRS announced the appointment of Cono Namorato as director of the IRS Office of Professional Responsibility (OPR). The Office oversees the activities of tax professionals under Circular 230, the Treasury Department’s standards for tax practice. Namorato, a veteran tax lawyer, was a partner at the tax boutique law firm of Caplin & Drysdale where former IRS Commissioner Mortimer Caplin was a name partner. Namorato started his career as an IRS agent, attending Brooklyn Law School at night, and then went into the honors program at the Justice Department. In 1978, he left the Department to join Caplin & Drysdale, where he did mostly criminal tax work.

Namorato and Everson shared the view that tax shelter practice at the time was an abomination. Up to that point, OPR had been confined to sanctioning tax practitioners for their own personal transgressions, such as the failure to file returns. Namorato believed that the office should promote the idea that tax professionals were partners with the IRS in helping ensure compliance with the tax system. In his first public remarks after being appointed, he explained that he hoped to transform OPR from a “backwater” office working on “overaged, insignificant cases” into an office that took more initiative.³⁷ Under Namorato, the office’s size doubled, and the number of enforcement attorneys on the staff tripled.

Namorato had to convince divisions within the IRS such as the Large and Mid-Size Business Division and CID to refer cases to OPR, since they historically had regarded the office as a “black hole” where “referrals went to die.” He encouraged CID to send him cases for which they couldn’t meet the criminal standard of beyond a reasonable doubt, since the standard for OPR action was lower. Namorato soon learned that OPR had no summons power because its authority was not based on the tax code but on the statute setting out the features of the Treasury Department. Undaunted, he began to use Section 10.20 of Circular 230, which provided that “[a] practitioner must, on a proper and lawful request by a duly authorized officer or employee of the Internal Revenue Service, promptly submit records or information in any matter before the Internal Revenue unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged.” Some members of the tax bar protested; OPR had never done anything like this before.

In the spring, the IRS announced a new Son of BOSS settlement, which IRS Commissioner Mark Everson had identified as the most widely used and problematic shelter in circulation. This offer gave investors ninety days to disclose their use of such shelters and pay the full amount of taxes and interest due. “This is the first time we’re saying, ‘concede 100 cents on the dollar,’” Commissioner Everson explained. According to Everson, the IRS had obtained the names of 2,000 of the estimated 5,000 taxpayers who had engaged in versions of the shelter, avoiding more than $6 billion in taxes. In addition to back taxes and interest, taxpayers who came forward would be liable for a percentage of the applicable penalties. The offer also provided no right of appeal.

Some at the IRS privately regarded the Son of BOSS initiative as a gamble because of the insistence on penalties and the elimination of an appeal. A small response by taxpayers could hurt the credibility of the agency so officials worked hard to promote the settlement through speeches and conversations with taxpayers and tax practitioners. Addressing the ABA Section of Taxation, John Klotsche, senior advisor to Everson, emphasized that the Son of BOSS shelter was especially suitable for a global settlement offer because it had a large unknown customer base, a defined factual template, and a similar tax benefit claim.³⁸ Responding to criticism that the IRS should not insist that participants in the settlement pay even a percentage of applicable penalties, Klotsche underscored that the agency was confident that full 40 percent penalties without any discount would be sustained in court. The taxpayers were savvy business people, he pointed out, and their reliance on promoter opinions was questionable.

The IRS gamble paid off. On July 1, 2004, it announced a “strong turnout” by taxpayers in response to the Son of BOSS settlement offer.³⁹ More than 1,500 taxpayers, about 85 percent of those known to the IRS, had come forward. In addition, more than three hundred previously unknown taxpayers had accepted the offer. According to the IRS, many taxpayers were involved in transactions with reported tax losses between $10 million and $50 million and that in several cases the claimed losses were more than $500 million. IRS Chief Counsel Korb sent a warning to those taxpayers who had not come forward. “[W]e plan an aggressive litigation strategy,” he said. “The word is getting out that there won’t be a better deal waiting if people take these cases to court.” The IRS ultimately concluded that about two-thirds of the known Son of BOSS investors took advantage of the settlement and the IRS recouped about $3.2 billion as a result.⁴⁰

Meanwhile, the Justice Department had begun criminal investigations of the tax shelter activities of Sidley Austin and Ernst & Young. The accounting firm had settled about a year earlier with the IRS, agreeing to a $15 million payment to settle its civil liability, and said that it was fully cooperating with the investigation. Observers suggested that the government likely was examining the conduct of individuals within the firm and expressed some skepticism that the government would bring an indictment against the firm not long after similar action against Arthur Andersen had led to the collapse of that company.⁴¹ E&Y of course hoped that its earlier settlement with the IRS would dissuade the Justice Department from indicting the company.

By the fall of 2004, a consensus had emerged that tax professionals at law and accounting firms had created an industry in abusive tax shelters and that Congress needed to act. On October 24, the American Jobs Creation Act (JOBS Act) went into effect. The Act eliminated purported ambiguities about which advisors were “promoters” of tax shelters for purposes of the registration and list-keeping requirements, imposing these requirements on all material advisors who assisted with or provided advice about reportable transactions and who received fees above certain thresholds. The statute also expanded the definition of a reportable transaction to include six categories of transactions specified in the final Treasury regulations. By broadening the registration requirements, the statute potentially imposed disclosure obligations on lawyers providing legal opinions in connection with shelters.

In addition, the statute significantly increased the penalties that applied to advisors and taxpayers for failure to disclose. For the first time, the JOBS Act imposed a penalty on a taxpayer for failure to disclose a reportable transaction, regardless of whether the transaction ultimately resulted in an understatement of tax. The JOBS Act also imposed higher penalties for understatements resulting from listed transactions and reportable transactions with a significant tax avoidance purpose. In addition, it strengthened the Office of Professional Responsibility, giving it authority over the preparation of tax opinions and law firms and empowering it to obtain injunctions against practitioners who violated Circular 230 and impose monetary penalties on individual practitioners and their firms.⁴²

The Prosecutors Move In

In 2005, the IRS announced two new settlement offers. In April, it gave investors in SC2, the shelter designed and promoted by KPMG to owners of S corporations, the opportunity to resolve the agency’s potential claims against them. In October, about a month after the Second Circuit summarily affirmed the trial court’s disallowance of tax losses in the Long-Term Capital case (discussed in chapter 9),⁴³ the IRS announced a settlement initiative for taxpayers and five additional transactions identified by the IRS.⁴⁴

By now, the drill was familiar. The IRS expected to recoup taxes due from a significant number of taxpayers who had participated in the shelters. It then planned to use the information it obtained to go after promoters and taxpayers who had not come forward. This would be the last global settlement initiative that the IRS offered; it saw no need for any more. The agency had finally dispelled “the generalized popular impression,” which had come out of the IRS Restructuring and Reform Act of 1998, that “the IRS was no longer going to enforce the law.”⁴⁵

On August 29, 2005, the U.S. Attorney’s Office in Manhattan indicted R. J. Ruble and nine other individuals in connection with KPMG’s tax shelter activity. (The prosecution is described in chapter 12.) Ruble was eventually convicted on ten counts of tax evasion and was sentenced to six and a half years in prison on April 1, 2009.

Earlier, the federal prosecutor’s office in Manhattan had announced that it would not seek criminal charges against Sidley Austin. The announcement noted that Ruble had done most of his work at Brown & Wood, Sidley had issued no opinions for mass-marketed shelters before the merger, and most of the opinions Ruble issued after the merger were in violation of the understanding that he would provide only a small number of opinions that he had already committed to write.⁴⁶ Simultaneously, the firm reached an agreement with the IRS to pay a penalty of $39.4 million to close the investigation of its role as a shelter promoter.⁴⁷ Sidley agreed to continue to cooperate with ongoing tax shelter investigations and declared that it had strengthened its internal procedures to prevent a recurrence of rogue activity such as Ruble’s.

In addition to civil and criminal government investigations, Sidley faced several lawsuits by shelter investors whose tax losses had been disallowed by the IRS. The most comprehensive catalog of litigation, contained in an article published in 2008, counted eighteen cases in which Sidley had been named as a defendant. One prominent suit was a class action against KPMG and Sidley that eventually settled for $178 million in June 2006.⁴⁸ Sidley was expected to pay about 20 percent of this figure, or $35.6 million. Under the settlement, plaintiffs received an average payout of between $700,000 and $750,000.

A week after the Sidley announcement, the government indicted former E&Y employees Robert Coplan, Richard Shapiro, Martin Nissenbaum, and Brian Vaughn on eight charges relating to their tax shelter work, including conspiracy to defraud the IRS, tax evasion, making false statements to the IRS, and impeding and impairing the lawful functioning of the IRS.⁴⁹ Charles Bolton, who owned investment companies that executed E&Y shelter transactions, was also charged and pled guilty before the trial. David Smith was charged but did not appear for trial, becoming a fugitive from justice. The firm was not charged, although the government made no announcement at the time about its fate one way or the other.

At trial, former E&Y employee Belle Six took the stand against Brian Vaughn and the other VIPER participants, providing critical testimony about how the defendants had presented CDS and CDS Add-On as legitimate business transactions. Six had earlier pled guilty to conspiracy to defraud the government and had already paid a penalty in excess of $13 million, the amount she netted from her tax shelter activities after taxes.⁵⁰ Six’s intense relationship with Vaughn had finally ended seven years earlier. At trial, Six told the jury, “Once I finally got him out of my head, I didn’t have any emotions personally anymore.”⁵¹

The defendants argued unsuccessfully that leaders in E&Y’s national tax office had known and approved of their activities. All four were found guilty of criminal tax fraud and offenses related to their efforts to mislead the IRS. In January 2010, the judge imposed prison sentences ranging in length from one year and eight months for Vaughn to three years for Coplan. Judge Stein added an unusual provision to the terms of Coplan’s and Nissenbaum’s supervised release after serving their prison sentences. Both men were required to warn about the dangers of misleading the Internal Revenue Service in speeches to lawyers, accounting firms, and bar groups, including, possibly, the ABA Section of Taxation. Stein explained the requirement in Coplan’s sentencing by saying that Coplan should “set forth his experiences and explain to these people the dangers of misleading the IRS, the dangers of going along with what everyone else is doing, the dangers of thinking all you are doing is your job . . . but realizing that, at some point, it tips over into criminal liability.”⁵²

The convictions ultimately represented a mixed victory for the government. In late 2012, the U.S. Court of Appeals for the Second Circuit reversed the convictions of Nissenbaum and Shapiro on the grounds that there was insufficient evidence to connect them to the tax shelter activities at the firm.

In February 2013, E&Y finally entered into a non-prosecution agreement with the Justice Department in connection with its tax shelter activities. Under the agreement, which covered its involvement in CDS, COBRA, CDS Add-On, and PICO, the firm agreed to pay a $123 million fine, representing the fees from these transactions. According to the statements of facts, the firm’s involvement in tax shelters was concentrated in the Strategic Individual Solutions Group (SISG), which was “primarily responsible for supervising and coordinating the marketing, implementation and defense of E&Y’s tax shelter products.” (The group, initially known under the acronym VIPER, is described in chapter 6.)⁵³

As the statement of facts described, in 2003 the firm had disbanded the SISG and settled a penalty promoter examination with the IRS, paying a $15 million fine. Since that time, E&Y had “implemented extensive changes to its governance and compliance procedures.” The firm had also substantially increased the number of its “legal and tax quality and risk management personnel.” The firm also created a Quality and Integrity Program, which required all tax professionals to enter data regarding a range of tax engagement matters for monitoring and to certify compliance with the program and the listing and registration requirements in the tax code. At the time, the IRS had praised the program as a model for an effective compliance program. E&Y had also implemented a series of procedures and practices to ensure legal and ethical conduct among its tax professionals and a series of mechanisms firm-wide, including an Ethics Oversight Board and an anonymous hotline to allow employees to raise concerns.⁵⁴ The statement of facts noted the timing of these changes, which occurred in response to the Permanent Subcommittee on Investigations’ investigation into the tax shelter industry in 2003.

The statement of facts emphasized that, unlike at some of the other accounting firms involved in the tax shelter industry, the senior management at E&Y did not participate in criminal wrongdoing and suggests that tax leaders were unaware of SISG’s activities. For example, it describes how SISG had hidden the similarities between CDS Add-On and COBRA, which the firm had already decided to discontinue, and created a cover story to give CDS Add-On a business purpose. (This incident is described in chapter 6.) Absent from the statement is an account of what tax leaders in the firm’s National Tax Department had envisioned when they created the tax shelter team in 1998 or how the group’s activities, which generated substantial fees, had occurred under their watch.

Closing the Book

Beginning in early 2009, a string of BDO partners pled guilty to tax fraud in plea agreements with the U.S. Attorney’s Office in Manhattan. On February 13, Michael Kerekes pled guilty to conspiring to defraud the United States and tax evasion. On March 17, Adrian Dicker pled guilty to the same two charges. On June 3, Charles Bee pled guilty to conspiracy to defraud the United States, tax evasion, and giving material false deposition testimony. Shortly after Bee’s plea, on June 9, the prosecutor announced the indictment of Denis Field and Robert Greisman of BDO, along with five other people: Jenkens & Gilchrist lawyers Paul Daugerdas, Erwin Mayer, and Donna Guerin, and Deutsche Bank employees R. Craig Brubaker and David Parse. A month later, on July 9, Greisman pled guilty to conspiring to defraud the United States, tax evasion, and corruptly endeavoring to obstruct administration of the tax laws. More than a year later, on October 19, 2010, Mayer pled guilty to conspiracy and tax evasion. As part of his agreement, Mayer agreed to forfeit his two residences and various bank and investment accounts worth more than $10 million.

Just before the end of 2010, the Justice Department closed out its criminal investigation of Deutsche Bank by announcing a non-prosecution agreement under which the bank would pay more than $553 million for its involvement in tax shelter activity from 1996 to 2002. The government said that this amount reflected the fees that Deutsche Bank earned from its involvement in tax shelter activity, the amount of taxes and interest the IRS was unable to collect from taxpayers, and a penalty in connection with the IRS’s examination of the bank as a shelter promoter. In return, the Justice Department agreed to refrain from prosecuting the bank for conspiracy to defraud the United States, tax evasion, and involvement in the preparation and filing of false and fraudulent tax returns.

The settlement indicated that Deutsche Bank had “participated in approximately 1,300 deals involving more than 2,100 customers, and implemented over 2,300 financial transactions related to these shelters.”⁵⁵ This reflected involvement in fifteen different abusive tax shelters. According to the government, the bank had “unlawfully, willfully, and knowingly” participated in shelter activity by “assisting tax shelter promoters to structure financial transactions that would be used to generate substantial tax benefits (generally losses), by preparing financial transaction documents that would be used by others to mislead the IRS regarding the true nature of the transactions, and by executing the transactions for the taxpayer clients of the promoters.”⁵⁶ Customers used the transactions in which Deutsche Bank was involved to claim $29.3 billion in unwarranted tax benefits, resulting in the evasion of $5.9 billion in taxes on ordinary income and capital gains.⁵⁷

The trial of Denis Field and the Jenkens & Gilchrist and Deutsche Bank defendants began on March 1, 2011. (The proceedings as they relate to the Jenkens defendants are described in chapter 12.) During trial testimony, Greisman, Dicker, Bee, and Shanbrom painted a detailed portrait of Field as someone who was deeply involved in the activities of the Tax Solutions Group and who monitored it closely. They described Field’s ongoing participation in important decisions regarding the group, such as its formation, its compensation structure, the approval of the Treasury short sales and short options strategy, discussions with some members of the group who expressed reservations about the shelters, the significance of Notice 2000-44, and BDO’s responses to requests for information from the IRS. Bee testified that he discussed with Field in New York in late 2000 the possibility of criminal penalties for themselves and for the firm because of the shelter activity. Field had responded that the IRS didn’t have the resources to handle all the cases that were arising so the firm should just stonewall the government.⁵⁸ Univer, BDO’s former general counsel, also testified and described how Field had never shared the Skadden memo with the firm’s board or other members of the Tax Solutions Group and how Field had represented to others at BDO that Skadden had approved the activities of the Tax Solutions Group.

In late May 2011, all the defendants except Brubaker were found guilty. A little over a year later, however, the court vacated the convictions of Field, Daugerdas, and Guerin in response to a motion for a new trial based on juror misconduct. The judge denied David Parse’s motion for a new trial on the grounds that his lawyers suspected, but failed to alert the court, about problems with the juror. Donna Guerin subsequently pled guilty to one count of conspiracy and one count of tax evasion. Each count carried a maximum of five years in jail. Guerin agreed to forfeit $1.6 million. A second trial against Field and Daugerdas resulted in a mixed victory for the government. Daugerdas was found guilty, but Field was acquitted of all charges. The jury may have concluded that Field, who was busy managing the firm, was too far removed from the tax shelter activity to know that the shelters were abusive.

In June 2012, the Justice Department and IRS reached a settlement with BDO Seidman. The firm admitted that it had helped generate $6.5 billion in fraudulent tax losses through its promotion of abusive tax shelters from 1997 to 2003, for which it had earned $200 million in fees. The estimated tax loss from this activity was $1.3 billion. The firm entered into a deferred prosecution agreement with the Justice Department under which a charge of tax fraud conspiracy against it would be dismissed in December if the firm continued to cooperate in the government’s criminal investigation. BDO also agreed to pay a $50 million penalty, $34.4 million of which would go to the IRS for the firm’s violation of shelter registration requirements.⁵⁹

The government also successfully concluded criminal prosecutions of several lawyers in private practice who had done work in connection with abusive tax shelters. On November 2, 2005, Graham Taylor, who had practiced at four different major law firms in San Francisco,⁶⁰ was indicted with five other people for conspiracy to commit tax fraud, wire fraud, and mail fraud, and for tax evasion in connection with a shelter that Taylor helped design known as Hybrid. The shelter involved the generation of fictitious currency transaction losses, false insurance expense deductions, and fraudulent capital losses that concealed $60 million in income and resulted in the evasion of $20 million in taxes.⁶¹ The indictment alleged that the scheme began in April 1994 and continued through late April 2005. The other defendants included three accountants, another lawyer, and an investment broker.

On January 24, 2008, the Justice Department announced that Taylor and two other defendants had pled guilty to conspiracy to commit tax fraud. On February 13, 2008, defendant Dennis Evanson, a lawyer, was convicted in connection with the scheme of conspiring to defraud the United States and to commit mail and wire fraud. His investment banker codefendant was acquitted on all charges. Evanson was later sentenced to ten years in prison and ordered to pay $2.7 million for his role in the shelter. Meanwhile, Taylor agreed to testify on behalf of the government in the trial of the four E&Y former employees that began in New York in March 2009. He was sentenced on October 29, 2009, to three years’ probation and a fine of $125,000. He resigned from the New York bar in December of that year.

In the fall of 2008 the Justice Department announced that Peter Cinquegrani, a former Arnold & Porter lawyer, had pled guilty to a criminal information charging him with conspiring to commit tax fraud, aiding and abetting tax evasion, and aiding in the submission of false and fraudulent documents to the IRS, all in connection with his work on PICO tax shelters. The government announced the same day that it had reached a settlement with Arnold & Porter, which paid a civil promoter penalty for its failure to comply with tax shelter registration requirements and its participation in the organization of listed transactions. Cinquegrani was sentenced to three years’ probation.⁶² Cinquegrani apologized to the court, explaining that “I think my desire to be a big shot, [to] feel that I was part of the in-crowd in the tax community, overrode my conscience.”⁶³ In imposing the sentence, the judge noted Cinquegrani’s cooperation with the government, which included explaining the PICO shelter to investigators. Earlier, Cinquegrani had been disbarred by the D.C. Court of Appeals based on his affidavit of consent to disbarment.⁶⁴

A few months after Cinquegrani’s plea, the Justice Department announced that Jay Gordon, former head of the tax practice at Greenberg Traurig, pled guilty to a two-count criminal information that charged him with conspiracy to defraud the United States in connection with the provision of shelter opinion letters, as well as with tax evasion with respect to his own tax liability. During this same period, John Campbell, formerly a lawyer at Miller Canfield, pled guilty to conspiracy to defraud the United States for his role in selling abusive tax shelters to his clients. His client, Oskar Rene Poch, pled guilty to corruptly endeavoring to obstruct the administration of the tax laws.

Campbell was sentenced to five years in prison, while Poch, who had cooperated with the government’s investigation and testified at the trial of the promoters, was sentenced to one year of probation and restitution and fines totaling more than $300,000.

In June 2009, Los Angeles attorney Matthew Krane was indicted by a grand jury in Seattle, along with Jeffrey Greenstein and Charles Wilk of the investment company Quellos, for their role in an abusive tax shelter scheme on behalf of Krane’s client billionaire Haim Saban.⁶⁵ He subsequently pled guilty to tax evasion in connection with a $36 million fee he received from Quellos for referring Saban to the company and to applying for a passport under a false name. In June 2011, he was sentenced to three years in prison. Krane also was ordered to return $17.9 million in fees to Saban (which Saban donated to charity) and to pay $23.1 million in back taxes.

Reinforcing Deterrence

Several important legislative initiatives occurred to strengthen the government’s hand in combatting tax shelters. A number of statutes have made it financially and personally riskier for taxpayers to engage in shelter transactions, and have increased the stigma for doing so. In 2006, Congress, recognizing the role of private enforcement of tax provisions, amended the moribund tax informant program, “breath[ing] life into the statute.”⁶⁶ The amendments created a centralized Whistleblower Office inside the IRS to process tips from informants about tax issues in the workplace. It also increased the awards that whistleblowers could receive for exposing tax law violations. Since 2008, the office has collected in aggregate $1,467,259,959 through the program and awarded $180,332,920 to informants.⁶⁷

Congress also codified the economic substance doctrine in March 2010.⁶⁸ Section 7701(o) of the Internal Revenue Code now provides that a transaction will be treated for tax purposes as having economic substance if it passes a “two-part conjunctive test.”⁶⁹ That test requires that a transaction “(A) . . . changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.” The statute provides that the determination of when the doctrine is relevant to a transaction “shall be made in the same manner as if [the legislation] had never been enacted.” Consistent with this language, the IRS indicated at the time of the statute’s enactment that it would “continue to rely on relevant case law under the common-law economic substance doctrine in applying” each part of the test.⁷⁰ There had always been significant differences of opinion as to whether codification of the doctrine would serve as a significant deterrent to abusive shelters.⁷¹ Placement of the doctrine in the Code at least meant that its use would no longer be dependent on courts’ acceptance of its legitimacy.

In addition to codifying the economic substance test, Congress amended the penalty scheme to create a “strict liability” standard when tax benefits are disallowed based on lack of economic substance. Under the new statute the penalty is 20 percent of the tax on the understatement if the relevant facts are disclosed in the return and 40 percent if no disclosure is made. The effect is to prevent taxpayers from relying on a tax opinion to avoid an accuracy-related penalty for a tax shelter transaction.⁷²

The shift to strict liability, in cases where tax benefits are disallowed due to lack of economic substance, eliminated the market for legal opinions intended to function as “get out of jail free” cards. Endorsing a “strict liability” approach back in 1999, the New State Bar Association Tax Section had explained:

[A]s a result of enactment of such a regime, . . . taxpayers [are] forced to incur a real risk from entering into such transactions, and [are] induced to seek balanced, well-reasoned tax advice concerning such transactions rather than tax opinions intended principally to serve as insurance against the imposition of penalties.⁷³

Other statutory initiatives have been effective in reducing the corporate appetite for shelters. These approaches shape the behavior of corporate taxpayers because they complement traditional reporting and disclosure requirements that already apply to corporations. According to one report on corporate tax planning,

there has been an environmental change in how companies approach tax planning in order to mitigate risk exposure. Companies are now more concerned than they have ever been about the diminution of their “brand value” arising from the disclosure of breakdowns in corporate governance processes, including those related to tax transactions.⁷⁴

The result is what tax scholar Susan Morse has called “the new public corporation tax shelter compliance norm.”⁷⁵ Morse notes that, in addition to IRS and Justice Department enforcement efforts, measures that have contributed to this norm include Sarbanes-Oxley (SOX), which requires publicly traded companies to institute internal control systems. SOX also limits he provision of audit and tax services by the same firm, and imposes other constraints that have expanded and altered the dynamics of the tax planning group in corporations.⁷⁶

A second measure that has decreased the demand for aggressive shelters is Financial Accounting Standards Board Interpretation No. 48 (FIN 48), an official interpretation of accounting rules issued by the Financial Accounting Standards Board. Enacted in the wake of the corporate accounting scandals at the turn of the century, FIN 48 contains two requirements that have dampened the corporate appetite for tax shelters. First, it requires that the incorporation of a claimed tax benefit in a company’s financial disclosures be premised on a conclusion that the tax position underlying the claimed benefit more likely than not will be sustained by a court. In addition, FIN 48 requires that claimed tax benefits that are not being incorporated into a company’s financial statements be disclosed nonetheless. Under this second requirement, companies are obligated to disclose aggressive tax strategies that do not meet the more-likely-than-not standard.⁷⁷

Beginning in the early 2000s, the IRS and the Justice Department effectively combined forces to identify and punish some of the major organizations and individuals involved in creating and selling abusive tax shelters. IRS administrative summonses, Justice Department enforcement actions, and John Doe summonses generated considerable information on both taxpayers and promoters. IRS settlement initiatives also provided information about shelter transactions that served as the basis for additional enforcement actions against promoters. Drawing on this information, the Justice Department launched criminal investigations of prominent accounting and law firms as well as of professionals working in them, subsequently indicting a number of individuals involved, obtaining guilty pleas and settlements, and securing a handful of convictions. All along, some commentators had insisted that the law governing tax shelters was too uncertain to support criminal prosecution. Through indictments and trials, the government succeeded in recasting the participants’ actions as abetting tax fraud. As the government showed, the issue was not, in the great majority of instances, that participants had genuine doubts as to the propriety of their activities. To the contrary, the tax professionals involved were well aware that the shelters they were promoting were abusive, but went to extraordinary lengths to hide the true purpose of the transactions and create the appearance that they were legitimate investment strategies.

The government initiatives ushered in a new climate for tax shelters. As chapter 12 describes, this new climate had profound implications for KPMG and Jenkens & Gilchrist, the two firms most deeply caught up in the tax shelter industry.