Tax Shelters: A Promoter Avoids Penalties Because He Merely Sold an Idea

tax shelter, 2An idea may be more powerful than the IRS, which recently lost a forty million dollar penalty case because a bankruptcy judge concluded that it takes more than an idea to have a tax shelter. In re Canada, No. 15-33757-BJH,  2016 Bankr. LEXIS 2234 (Bankr. N.D. Tex. June 7, 2016).

Canada involved penalties under the old version of Section 6707 of the Internal Revenue Code, I.R.C. § 6707 (1998). The penalties were assessed against William Canada, the taxpayer, on the theory that he had participated in the sale or management of an unregistered tax shelter in violation of the historical version of Section 6111, I.R.C. § 6111 (1998).

Mr. Canada was a lawyer who stopped practicing and started working at Heritage Organization, LLC (“Heritage”). By 1998, the taxpayer was heavily involved in its sales efforts; Canada would also play a variety of other roles at Heritage. Canada, 2016 Bankr. LEXIS 2234 at *6-*7. What the taxpayer and Heritage were selling was a basis inflation strategy generally known as “Son of BOSS.”

The bankruptcy court explained the strategy in the following terms, based on the taxpayer’s testimony:

  • after establishing a brokerage account through a pass-through entity, the client would sell Treasury securities short, investing the proceeds into reverse repurchase agreements;
  • the client’s “brokerage account would be contributed to a partnership”; and
  • “the lawyers opined that the client created basis in the partnership equal to the amount of the proceeds of the Treasury short.”

Id. at *11-*12 (footnote omitted). A key feature of this strategy was that the client’s obligation to replace the Treasury securities was ignored in determining his basis in the partnership; this was done on the theory that the obligation was a contingent liability. Id. at *13. While it generally described what was being sold as an idea or a strategy, the court referred to the strategy as the “Heritage Transactions.”

The bankruptcy judge found that Canada “was not attempting to sell shares of a particular brokerage company or law firm. Instead, the product that Canada sold was an idea-i.e., a strategy for producing incredible tax savings that Heritage would reveal to its clients for a (very high) price.” Id. at *14. The clients signed contracts for Heritage to share these strategies designed to generate favorable tax results. Id. at *14-*15. The clients agreed not to share the strategies with others and were subject to substantial fees if they did so. Id. at *17.

In early 2007, the IRS advised Canada that it was investigating him for potential penalties under Section 6707. Over eight years later, in April 2015, it advised Canada that it intended to pursue the penalties, and the taxpayer filed a bankruptcy petition in September of that year. Id. at *19.

The bankruptcy court confronted the case in the context of the taxpayer’s objection to an amended proof of claim filed by the IRS. It commenced its analysis by focusing on the historical versions of Sections 6111 and 6707 that were in place when Canada was working for Heritage, noting that “the statutes that control Canada’s potential liability are complicated and technical; and there is next to no case authority interpreting those statutes.” Id. at *24. Accordingly, the court turned to the text of the applicable version of Section 6111, which required that “[a]ny tax shelter organizer shall register the tax shelter with the Secretary (in such form and in such manner as the Secretary may prescribe) not later than the day on which the first offering for sale of interests in such tax shelter occurs.” Id. at *24-*25 (quoting I.R.C. § 6111(a) (1998)).

In light of the language of Section 6111(a), the court concluded that Canada was only subject to the registration requirement if the strategies he sold were a “tax shelter,” and if he was a “tax shelter organizer.” Id. at *25. Accordingly, the court turned to the statutory definition of a tax shelter, which is as follows:

The term “tax shelter” means any investment—
(A) with respect to which any person could reasonably infer from the representations made, or to be made, in connection with the offering for sale of interests in the investment that the tax shelter ratio for any investor as of the close of any of the first 5 years ending after the date on which such investment is offered for sale may be greater than 2 to 1 . . . .

I.R.C. § 6111(c)(1) (1998).

Here, the court focused on the use of the term “investment” in Section 6111(c)(1), as well as the phrase “in connection with the offering for sale of interests in the investment” in Section 6111(c)(1)(A), which served as the focus of the taxpayer’s argument that he was not subject to the registration requirement because he was not promoting an “investment.” The court then contrasted the definition under Section 6111(c), which required an investment, with Section 6111(d), which provided that confidential arrangements and plans were deemed to be tax shelters, but only if a corporation was a participant. Canada, 2016 Bankr. LEXIS 2234 at *27; see also I.R.C. § 6111(d)(1) (1998) (embracing “any entity, plan, arrangement or transaction”). The juxtaposition of these two definitions led the court to posit that the terms “entity, plan, arrangement or transaction” were not embraced within the term “investment” under the Section 6111(c)(1) definition of a tax shelter. 2016 Bankr. LEXIS 2234 at *28.

After touching briefly on the statutory definition of a “tax shelter organizer,” the bankruptcy court focused closely on the question whether Canada was involved in selling an “investment” that was a “tax shelter.” Noting that Section 6111(c)(1) described an investment as something in which interests were sold, the court concluded that the Heritage Transactions that Canada sold were not investments: “[j]ust as someone who offers to tell you for a price which tech stocks are booming or what Manhattan real estate is appreciating is not selling you shares in Google or an interest in the Flatiron Building, Canada was not selling an investment . . . .” Id. at *36.

The court reinforced this conclusion by invoking the principle that statutes should be construed to give effect to all of their parts; applying this canon of construction, the court reasoned that reading the Section 6111(c) definition to reach the “Heritage Transactions” would effectively read the broader definition of Section 6111(d) out of the statute, as there would be no need to use the terms “plan, arrangement or transaction” if “investment” already embraced them. Id. at *37-*38. Finally, the bankruptcy court invoked the principle that any ambiguity in a tax penalty statute should be construed against the government. Id. at *39-*40.

Having concluded that Canada had sold an idea or a strategy, not an investment, the court determined that the Heritage Transactions were not tax shelters subject to the registration requirement under Section 6111. Consequently, Canada was not liable for penalties under Section 6707 as there was no violation of 6111. Id. at *45-*46.

For good measure, the bankruptcy court considered what Canada’s liability would be if its determination that Canada was not involved in the sale of a tax shelter was incorrect. Here, the court readily concluded that Canada was a “tax shelter organizer” if the strategy that he sold was a tax shelter. Id. at *46-*49. Even under that scenario, however, the bankruptcy court concluded that the taxpayer should not be penalized because he had a reasonable basis to conclude that registration was not required. Id. at *49-*64.

The real significance of the case, however, does not lie in these alternate holdings but in the court’s determination that selling an idea is not selling a tax shelter. It will be interesting to see how this case progresses; given its broad sweep, an appeal by the government would seem to be inevitable.