Bill Yung and Columbia Sussex Sue Grant Thorton

I am reading Yung v Grant Thornton. This is a mammoth decision – it runs over 200 pages.

William Yung (Yung) owns a hotel and casino company (Columbia Sussex) based in northern Kentucky. I remember meeting with some of his tax people several years ago.  I have watched fireworks from his Kentucky office location.

Then there is Grant Thornton (Grant), a national accounting firm, and its former partner, Jon Michel (Michel). Jon and I worked for the same accounting firm, although not at the same time. I remember having lunch with Jon a few years later and discussing joining Grant Thornton’s tax team. I also remember the unacceptable sales pressure that went with joining Grant. I passed on that, and I am glad I did.

Jon is in the tax literature, and not in a good way. It has a lot to do with that sales pressure.

Today we are talking about tax shelters.

CPA firms - especially the nationals - in the 1990s and aughts became almost pathologically obsessed with profitability. Accounting practice was changing, and the tradition of accountants being business advisors and confidantes was being replaced with a new, profit-driven model. We saw metrics like “write-ups” and “write-downs” by individual accountants. There were “individual” marketing plans for accountants two or three years into the profession and having another five or seven job changes ahead of them. I remember a CPA whose promotion to manager was delayed because she missed her “chargeable” budget by approximately 40 hours – over the course of an entire year.

And tax departments were leaned upon to come up with new “products” to market to clients.

COMMENT: Referring to tax advice as a “product” tells one a lot about the underlying motivation of whoever is promoting it. I for example do not sell a “product.” I provide business and tax advice. If you want a product, go to Amazon.

So what flavor of tax shelter are we talking about?

Yung and family and family entities (such as Columbia Sussex) own casinos and hotels. Some of them are in the Cayman Islands, which would make them controlled foreign corporations (CFCs). You may recall that the U.S. wants to tax all U.S. businesses on their worldwide income. Since doing so would almost guarantee that there would be no U.S. - based international businesses, the tax Code allows for tax deferrals, then exceptions to those deferrals, and then exceptions to the exceptions, and so on. It borders on lunacy, frankly, but this is what Yung and entities were caught in. Yung and entities had monies overseas, but it would have cost a fortune in taxes to bring the monies back to the U.S. Yung’s son Joe traveled regularly to the Caribbean, Central and South America seeking acquisition opportunities as a means to reinvest the Cayman monies. Grant was their accounting firm. Jon Michel even assisted in the acquisition of a Canadian hotel.

There was opportunity there for a sharp tax advisor.

Here is opportunity knocking:

·        A partnership contributes cash to a foreign corporation (FC). It receives the common stock.

·        Another party also contributes cash. In return it receives preferred stock.

·        The FC borrows money from a bank.

·        With the money, the FC buys marketable securities.

·        FC then distributes the securities, with its attendant debt (sort of), to the partnership, liquidating the partnership’s investment in FC.

·        There is a technical tax rule concerning a distribution with debt attached. The debt reduces the fair market value of the securities. If the debt were equal to the value of the securities, for example, the net distribution would be zero (-0- ).

·        The partnership received a liquidating distribution worth zero (or near zero) but had an investment equal to the cash it put in FC. This leads to a big tax loss.

So far, so good. The partnership received marketable securities, but it also has to pay back the bank. Where is the tax shelter, then?

·        The FC later pays off the debt.

Whoa!

The partnership is out no money but has a big tax loss.

The key to this was being able to reduce the liquidating distribution by the bank debt, even though the partnership never intended to pay the debt. Some tax CPAs and tax attorneys argued that this was fine, as tax Code Section 301(b)(2)(B) reduced the distribution…

“… by the amount of any liability to which the property received by the shareholder is subject immediately before, and immediately after, the distribution.”

We are talking the Bond and Optional Sales Strategy tax shelter sold by Price Waterhouse in the 1990s. The nickname was BOSS, and the IRS was determined to come down hard on the BOSS transactions and enablers. Frankly, I don’t blame them.

In 1999 the IRS published Notice 99-59, which warned that tax losses claimed in a BOSS transaction were not allowable for federal income tax purposes. The Service also warned of substantial and numerous penalties.

Congress followed this up with new tax Regulations to Section 301 in 2000.

So what did Grant Thornton do? It developed a new “product” which it called “Leveraged 301 Distributions” or Lev301.  How did it work? Here is an internal Grant document:

           

The objective of the Leveraged 301 Distributions tax product is to structure distributions in order to permanently avoid taxability to shareholders. Either closely-held C corporations or S corporations can distribute assets subject to liabilities … and provide this benefit to shareholders.”

           

How similar is this thing to BOSS, which provoked Notice 99-59 and new tax Regulations? Back to that Grant internal document:

Further the IRS may assert arguments it used against the BOSS transaction in Notice 99-59 and against the subject-to language of former IRS Section 357”

This has to be a finalist for the “Worst Timing Ever” award.

Grant goes live with the product in June 2000. Jon Michel begins to promote the thing, including to Yung and Columbia Sussex.

You already know this thing went to trial, so let’s fast-forward to some language from the Court:

           

No one associated with Grant Thornton, even those intimately involved in the process who testified to the court, has stepped forward and taken credit for the idea and creation of Lev301.”

Hey, but Lev301 is substantially different from BOSS, right?

Here is the Court:

Grant Thornton believed that there was a 90% chance that the IRS would disallow the tax benefits on the Lev301 on audit.”

Good grief! Why would a self-respecting tax advisor be associated with this?

Yung and Columbia Sussex were not told about the 90% chance.

The court finds that Yung and associates brought income into the United States from his CFC’s on a routine basis. Yung and his associates looked for ways to accelerate this process but vetted possible means of doing so with a close concern for the risks involved, as evidenced by the decision not to participate in other tax strategies presented to them. Yung and his associates maintained a very conservative risk level about income tax reporting as evidenced by the IRS complimenting the consistent approach to paying taxes. The court finds the Yung’s testimony to be consistent with this approach to tax reporting and, therefore, to be credible.”

What did the Court say about Grant?

The evidence indicates everyone who participated was on high alert regarding this product. As a result, while this court certainly understands the fading of memory, the failure of some of Grant Thornton’s witnesses to recall anything about their participation in the research and development of this product is disingenuous and not credible.”

Let’s continue. Would Jon Michel have been permitted to meet and pitch Lev301 to Yung had Yung’s tax department been informed of the risk?

The likelihood that the IRS would view the Lev301 as an unlawful abusive tax shelter was a present risk that would have impacted … (Columbia Sussex’ CFO) decision to allow …. J(on) Michel to present Lev301 to Yung. Had the risk been disclosed … (Columbia Sussex’ CFO), (as he had done with the prior proposals) would have terminated discussions about Lev301 at that point.”

So Jon Michel and Yung meet. Yung wanted to know if other Grant clients had used this scheme.

J(on) Michel told Yung that, while he could not divulge the names of other Grant Thornton clients, he could disclose that a local jet-engine manufacturer and a local consumer products manufacturer had successfully used the Lev301 strategy to transfer foreign wealth to the U.S.”

For those of us who live in Cincinnati, the reference to GE and Proctor & Gamble is unmistakable. Still, if GE and P&G did use the strategy…

When Michel made this representation to Joe Yung, he had no knowledge as to whether GE and P&G had utilized a Lev301-like strategy.”

All right then.

In 2002 the IRS initiated an examination of Grant Thornton. The IRS issued a summons asking for documents relating to Grant’s promotion of Lev301 and the names of clients who participated in the product.

Grant Thornton did not notify the Yungs … about the summons, which further increased the likelihood that the Yungs … would be audited by the IRS on account of their participation in the Lev301.”

In November of 2002 the IRS audited Columbia Sussex for reasons unrelated to Lev301.

NOTE: This is fairly common for larger, higher-profile corporations. It does not necessarily mean anything.     

Grant was hired to represent during the tax audit.

In 2003 Yung and Columbia Sussex received an Information Document Request from the IRS. The IRS wanted to know whether they had directly or indirectly participated in any transactions that were the same or substantially similar to a “listed” transaction.

            NOTE: Like a BOSS or a BOSS-like transaction.

Jon Michel answered the question “No.”

The tax director at Columbia Sussex later read in a trade journal that the government was summoning Grant Thornton. He called Jon Michel. Jon informed Yung and associates that Grant was likely to comply with the summons and that client names would be turned over to the IRS.

And they were.

The IRS expanded its audit of Columbia Sussex to include more years, the Yung family, family entities and any unfortunate soul driving past corporate headquarters on I-275 in northern Kentucky. On the other hand, in 2004 Jon Michel wrote a nice letter to Yung and entities offering limited tax representation before the IRS.

Do we need to continue this story?

The Yung family and entities owed over $18 million in tax, interest and penalties to the IRS.

If this were you, what would you do next?

You would sue Grant Thornton.

           

COMMENT: Be honest: this is a Mr. Obvious moment.

A Kentucky circuit court has just ordered Grant Thornton to pay Yung and family and entities approximately $100 million, including $80 million in punitive damages. The judge described Grant’s actions as “reprehensible.”

Grant intends to appeal, saying:

We are disappointed in the Court’s ruling and believe we have strong grounds for an appeal, which we will pursue.”

Grant has to appeal the decision, of course.

My thoughts?

Remember that Yung is in the hotel and casino business, an industry subject to higher financial and personal scrutiny. What is the collateral and reputational damage to him and his entities from an abusive tax shelter? Yung has said the ordeal has already cost him a casino license in Missouri.

I have little patience for this type of practice. What was motivating Grant with the Lev301 “product”- solving a client’s tax problem or generating a million dollar fee? Could it be both? Sure, but the smart money would bet the other way. This type of behavior is not “practice.” It is greed, it is an abuse of a professional relationship and it is disreputable to those of us who try to practice between the lines.

When A Tax Shelter Blows Up

Can you image losing a tax case with the IRS and owing a billion dollars?

Who did this? We are talking about Dow Chemical Company (“Dow”). They lost in the District Court for the Middle District of Louisiana. I suppose they have no choice but to appeal. It is a billion dollars, after all.

What got them in this mess? 

A couple of tax shelters, one marketed by Goldman Sachs and both implemented by the law firm of King & Spalding. The IRS sued for tax years 1993 to 2003. 

Let’s talk about the first of the shelters – called a SLIP – which lasted from 1993 to 1997. Dow was not the only one that tried to SLIP the IRS. Merck and International Paper tried also.

SLIP stands for “Special Limited Investment Partnership.”  Its claim to fame was taking low-basis assets and turning them into tax deductions.  How would you do this? Well you could contribute them to a partnership, but that low basis would carryover. You would get no increased tax deduction by putting it a partnership.

Hmmm.

What if you put low-basis assets into a partnership and then leased them back?  Wait, the partnership would then have taxable income. Who would own the partnership? If you owned it, then the whole effort would be circular. 

What if there are other partners? Problem: you do not want other partners. 

What if you limit the other partners to a fixed return? It would be the same as paying interest to a bank, right? In partnership taxation we call this a priority or preference distribution. 

Problem: most of that income would be coming back to you. How can we solve this puzzle?

We delink the income distribution from the cash distribution. We bring in partners who will accept 6 or 7 percent priority, and we allocate virtually all the income to them.

Now why would someone agree to this?

If someone doesn’t pay U.S. tax, that’s why. Someone like a foreign bank.

Eureka!

You offer a foreign bank the deal, now referred to as a “structured financial transaction.” This means that it is complicated, and you will be paying top dollar for investment, legal and accounting advice. You explain to the bank that it would:

·        Receive a significant premium over a corporate bond

·        Take on less credit risk than a corporate bond

·        Escape any U.S. tax

Sure enough, Dow and Goldman Sachs rounded up five foreign banks willing to contribute $200 million. Dow set up a maze of subsidiaries, into which it dumped 73 patents. The interesting fact about these patents is that Dow had amortized them virtually to zero, Dow still used them in current operations and retained enough of the processes to make it unlikely anyone would want to buy the patents, though.  The patents appraised at $867 million.

One of those Dow subs contributed the patents into a partnership called Chemtech I, taking back an 81 percent ownership.

Dow paid Chemtech I around $143 million for use of the patents.

Chemtech I paid the foreign banks 7 percent as their priority return. Since the banks had invested $200 million, this was a cool $14 million in their pockets. Chemtech I paid a couple of other things, took the remaining cash and put in a subsidiary. That subsidiary loaned the money back to Dow. How much cash did it loan back, you ask? About $136 million. For one year.

On its tax return Chemtech I reported approximately $122 million in income. It allocated $115 million of that to the banks. Only $28 million in income went back to Dow itself.

What we have just talked about is known in tax lingo as a “strip.”

And there is the SLIP. All Dow did was move money around. It paid the foreign banks $14 million in interest but called it a priority, thereby dragging over $115 million of income with it. As the banks did not pay U.S. tax, they did not care. Dow however did.

In 1997 there was a change in U.S. tax law, and Dow had to switch to another tax strategy. Dow wanted to cash out the banks and start something else.

The banks wanted their share of the market value of those patents on the way out. Seems fair, as they were “partners” and all. Dow said “no way”. The partnership agreement stipulated how the patents were to be valued and how to calculate the banks’ share. Dow paid the banks approximately $8 million. The banks complained, but to no avail. Dow controlled the calculation of value.

Once the banks were out of the way, Dow created a second tax shelter using a fully-depreciated chemical plant in Louisiana. This strategy did not require banks, but it did employ a very clever maneuver to pump-up the basis of the plant, thereby creating depreciation deductions that Dow could use to offset real income from other sources.

Oh, there was a formidable tax issue that Dow resolved by ripping up a piece of paper and replacing it with another.

OBSERVATION: And there you see the IRS’ frustration: Dow is not dealing with independent parties. In Chemtech I, it was dealing with banks acting as banks. Dow called them partners, but it may as well have called them peanut –butter sandwiches for the difference it made. In the second deal (called Chemtech II), Dow did not even leave the ranch. It replaced a deal between its subsidiaries with another deal between its subsidiaries. Really?  No wonder the IRS was hot around the ears.

So the IRS gets into Dow’s tax returns. In 2005 it issued a Notice of Final Partnership Administrative Adjustment for tax years 1993 and 1994. Dow responds that the IRS did not give the notice to the properly designated person – the Tax Matters Partner – and the notice was therefore invalid.

OBSERVATION: The tax matters partner rule is to protect both the partnership and the IRS. It means something when you have big partnerships with hundreds if not thousands of partners. Dow however was setting up partnerships like they were jellybeans. I find it cheeky – to be polite – that Dow’s defense was “you sent the mail to the wrong cubicle.”

This thing goes back and forth like a tennis match. In the end, a court has to decide. The IRS had scooped up additional years – through 2003 – by the time this was resolved.

How would the IRS attack the shelters?

There are a couple of ways. The first is the “economic substance” doctrine. Think of it as the tax equivalent of “where’s the beef?” The court looks at the transactions and determines if there is any reality to what supposedly is going on. There are three prongs to this test:

(1) Does the transaction have economic substance compelled by business or regulatory realties;

(2) Does the transaction have tax-independent considerations; and

(3)  Is the transaction not designed in toto with tax avoidance intent?

The Court looks at the SLIPS and observes the obvious:

(1) The SLIPs did not change Dow’s financial position in any way. Chemtech I could not have licensed those patents to a third party if it wanted to, as it did not own all the rights. This means that Chemtech I could not produce independent revenue. That is a problem.

(2) The cash flow was circular. The little bit that left (to the banks) was the equivalent of interest. Big problem.

(3) Dow argued that it was preserving its credit rating and borrowing power, but it could not prove any increase in its credit rating or borrowing power. Dow also stumbled explaining why it structured the transaction this way rather than another way – like having domestic banks in Chemtech I.

The second way the IRS attacked was by arguing the partnership was a sham. This argument is slightly different from “economic substance,” as that argument looks at transactions. The sham partnership argument looks at the partnership itself and asks: is this a real partnership?

The Court notes the following:

·        The banks got a priority of 7%.

·        The only room left for the banks to profit was if the patents went up in value. The banks were only allocated 1% of that number, and Dow controlled how to calculate the number.

·        When the banks complained about their lousy 1%, a Dow executive called them “greedy.”

OBSERVATION: It was clear the Court was not impressed with this executive’s comment.

·        It was virtually impossible for the banks to lose money.

·        The one risk to the banks – IRS challenge – was indemnified by Dow.

The Court observed that true partners have the risk of loss and the hope of gain. The banks had virtually no risk of loss and sharply limited room for gain. There may have been a banking relationship, but there was no more a partnership here than in a Kardashian marriage.

The Court said the shelters were bogus and Dow owed the tax.

And a 20 percent penalty to boot.

MY TAKE:  Those who know me, or who follow this blog, know that I generally side with the taxpayer. After all, it is the taxpayer who sets an alarm clock, takes on a mortgage or builds a website that actually works, whereas the government is little more than weight in the trunk.

Still, at least pretend that there is some business reason for all the tax fireworks that are going off.

This court opinion is 74 pages long. While I am somewhat impressed with the tax wizardry that Dow brought to bear, I must admit that I am reading tax planning for its own sake. That may groove someone like me, but that is not enough to pass muster. There has to be a business purpose for moving all the pieces around the board, otherwise the IRS can challenge your best-laid plans.

The IRS challenged Dow. 

Dow lost.
 

Two Brothers, An Offshore Trust And An Ignored CPA

Here is the cast of characters for today’s discussion:

Brian             orthopedic surgeon and idiot tax savant

Mark             Brian’s brother and idiot business manager

Michael         long-suffering CPA

Lynn              the “other” CPA

All right, maybe I am showing some bias.

Let us continue.

The two brothers attend a seminar about using domestic and offshore trusts to delay taxes until the monies were brought back into the United States. In the meanwhile, one could tap into the money by using a credit card.

Sure. Sounds legit.

The brothers return and are excited about this new tax technique. They ask Michael’s advice. Michael tells them that the seminar promoter was “a person to avoid” and to consult an independent tax attorney. 

Brian blew off Michael. Brian signed up for the offshore trust. He may have received a toaster with his new account.

Michael – who does the accounting - sees a $15,000 check to the promoter. He writes Brian:

I am writing to you because I am concerned for you and the risks you may inadvertently be taking.

It seems to me that the promoters are relying on an elaborate chain of complex entities to conceal taxable income. I am especially suspicious when I learned that they will provide you with a VISA card to access the money.

I am asking that you consider the worst case scenario in which the IRS takes the position that you are committing tax evasion. They have the power to assess huge penalties and interest, to prosecute you, to ruin your career, and seize your property. Is the risk worth it?”

Michael talks with Mark. He believes that the brothers have finally listened to his advice.

Meanwhile, the brothers did not listen to anything. They set up a series of interlocking companies and hired Lynn to prepare taxes for those companies. Lynn is associated with the promoters of this tax scheme.

• In year one the brothers transfer $107,388 offshore and deduct it as management fees 
• In year two they transfer and deduct $199,000 
• In year three they transfer and deduct $175,000

The IRS swoops in on the trust promoters. They take Lynn’s computer. Lynn calls Mark, explains all that, and recommends that they see a tax attorney. Maybe they should amend the tax returns.  Mark, after his many minutes of tax education, training and experience, told Lynn that he was not amending anything.

It gets better.

The promoter contacts the brothers and says that they have a NEW AND IMPROVED program that will be bulletproof against the IRS. The brothers sign on immediately.

The brothers receive their sign soon thereafter. 

• In year four they transfer and deduct $650,000

Michael is preparing this tax return. He calls Mark and asks about the “management fee.” Michael has Mark write him a letter that all was on the up-and-up.

• In year five they transfer and deduct $460,000

Michael is not preparing this tax return. He has had enough, and he has a career to protect. He wants a letter from an attorney that the transactions are above board.

Mark fires Michael.

And, in another surprise, daytime was followed by darkness.

A year later, Michael (the hero of our story) sends the brothers a press release about the “dirty dozen tax scams.” Sure enough, theirs is on the list. There is still time to send back the sign.

• In year six they transfer and deduct $180,000

In addition, Brian taps the offshore account for $270,000 for the purchase of a new home.

A couple of years later Michael receives a subpoena from the IRS for records pertaining to Brian and his company. This is when all that communication back-and-forth with Mark and Brian may have taken its toll, as Brian was virtually giving the IRS a roadmap.

The brothers, perhaps whiffing that they may have missed a key lecture in their vast tax education, decided to amend Brian's personal returns, adding most of the so-called management fees back to his income. Brian sends a big check to the government.

This case goes to Court. This is not a regular tax case. No sir, this is a fraud case. Someone is going to jail.

There was an eleven-day trial. The brothers were found guilty on all counts.

There was something interesting in here during interrogatories. The IRS never discussed the amended returns when they were presenting their fraud case. The brothers objected, but the Court sustained the government. The brothers introduced the amended returns when it was their turn.

The brothers had a point. The government was not out ALL the money, because Brian had paid a chunk of it with the amended returns. Why then did the Court sustain the government? Here is the Court:

As an initial matter, we note that the amended returns were submitted years after the false returns had been filed and months after[Michael] warned [the brothers] that their records had been subpoenaed. We have previously said that ‘there is no doubt that self-serving exculpatory acts performed substantially after a defendant’s wrongdoing is discovered are of minimal probative value as to his state of mind at the time of the alleged crime.”

Wow. There were no brownie points with this Court for doing the right thing.

By the way, Brian got 22 months at Club Fed and his brother got 14 .

But they got to keep the sign.