An Entirely Different Kind of Tax Shelter Case

tax shelter 1In the typical tax shelter case, the government is on offense, seeking to blow up a tax shelter and recover taxes and penalties. Last week, a district judge addressed a very different sort of case with a very different sort of posture: The government was playing defense, as the IRS was accused of knowing participation in a breach of fiduciary duty by the plaintiffs’ accountants. Esrey v. United States, No. 16-cv-3019 (JPO), 2017 U.S. Dist. LEXIS 42300 (S.D.N.Y. Mar. 23, 2017).

The plaintiffs, William T. Esrey and Ronald T. LeMay, were the former Chief Executive Officer and Chief Operating Officer of Sprint Corporation. Both used Ernst & Young (E&Y) as their tax advisor and financial planner. Esrey, 2017 U.S. Dist. LEXIS 42300 at *2. Based on advice from E&Y, Esrey and LeMay entered into two contingent deferred swap transactions in 1999 and 2000. Id. E&Y also served as Sprint’s auditor. Id. Sprint’s board authorized new employment contracts for Esrey and LeMay in February 2001; at that time, the board was aware that the two had entered into the swap transactions based on E&Y’s advice. Id.

In March of 2002, the IRS commenced an audit of E&Y’s activity in promoting tax shelters; it also began to audit the taxpayers who had invested in the shelters. Id. at *2-*3. On June 21, 2002, the U.S. Attorney’s Office for the Southern District of New York informed E&Y that it was initiating an investigation into E&Y’s conduct in promoting tax shelters. Id. at *3. Meanwhile, E&Y was representing Esrey and LeMay before the IRS in connection with audits. Id.

Sprint’s board became concerned about the prospect for conflict between the plaintiffs and E&Y; in 2002, it required Esrey and LeMay to certify each quarter that they had no intention of suing E&Y. Id. In December of 2002, the plaintiffs suggested that Sprint terminate E&Y’s engagement as auditor to resolve the conflict. Id. at *3-*4. For its part, E&Y met with Sprint’s board and told the board that its advice to Esrey and LeMay was sound and its actions were proper; it did so while it knew it was under criminal investigation for that advice and those actions. Id. at *4.

The plaintiffs’ effort to oust E&Y backfired: The board asked for the plaintiffs to resign; it concluded that the conflict of interest between the plaintiffs and E&Y was too serious to ignore, and it also concluded that firing E&Y would generate adverse publicity. Consequently, the two plaintiffs resigned in April and May of 2003. Id.

Esrey and LeMay apparently first learned that E&Y was under investigation in May 2004, when the criminal investigation of E&Y became public. Reasoning that knowledge of the criminal investigation would have been useful in their dealings with Sprint’s board, Esrey and LeMay filed an action under the Federal Tort Claims Act. In their complaint, the plaintiffs alleged that E&Y had breached its fiduciary duty to them by continuing to represent them before the IRS while concealing the criminal investigation and that the IRS had participated in that breach by actively concealing the investigation from Esrey and LeMay. Id. at *4-*5. Among other things, the plaintiffs alleged that they were prevented from defending themselves adequately before Sprint’s board because they were unaware of the investigation of E&Y. Id. at *4. Esrey sought to recover $42,500,000 in damages from the United States, and LeMay sought $116,800,000.

In response, the government moved to dismiss for lack of subject matter jurisdiction and for failure to state a claim for relief; its jurisdictional motion focused on sovereign immunity, which proved dispositive.

While the Federal Tort Claims Act, 28 U.S.C. §§ 2671-2680, provides a waiver of sovereign immunity, there are exceptions to that waiver. One exception applies to “[a]ny claim arising in respect of the assessment or collection of any tax.” 28 U.S.C. § 2680(c). A second applies to “[a]ny claim arising out of . . . misrepresentation [or] deceit.” 28 U.S.C. § 2680(h).

The district court granted the government’s motion, concluding that the plaintiffs’ claim was based upon misrepresentation:

Plaintiffs’ claim that the Government participated in EY’s breach of fiduciary duty collapses into a claim that the IRS’s alleged concealment prevented Plaintiffs from learning about and then utilizing information that may (or may not) have changed the outcome of the Sprint Board meetings that led to their forced resignations.

Esrey, 2017 U.S. Dist. LEXIS 42300 at *9 (emphasis by the court).

The plaintiffs pointed to other actions that did not amount to concealment, but their efforts were unavailing. First, they alleged that E&Y had increased its settlement offer in its audit to persuade the IRS to remove the word “penalty” from a June 2003 press release announcing the settlement of its audit of E&Y and its promotion of tax shelters. Id. at *10-*11. The district court noted, however, that it was “logically impossible” for this action to have impaired their ability to defend themselves before Sprint’s board months earlier. Id. at *11. Second, the plaintiffs argued that the IRS had failed to follow its own procedures to address E&Y’s conflict of interest. The court observed that this was not actionable because taxpayers do not have a right to enforce the provisions of the Internal Revenue Manual.

This is plainly the correct outcome. While E&Y should not have continued to represent clients before the IRS during the criminal investigation concerning the transactions at issue, that is an issue for the client to take up with his accountant. Apparently, Esrey and LeMay did so, as the court’s opinion indicates that they recovered from E&Y in an arbitration. Id. at *5 n.2. Perhaps the IRS should have done more to keep E&Y from continuing to represent the plaintiffs, but Esrey and LeMay were sophisticated business people; they knew that their representative had a conflict of interest because its advice was at issue in their audits. What they did not know was just how serious that conflict was.