United States

Taxpayer had reasonable cause to claim losses related to tax shelter

TAX ALERT  | 

On Feb. 24, 2017, the U.S. District Court of Wyoming issued its unpublished order in McNeill v. United States in which it determined that Mr. McNeill, a retired U.S. Navy nuclear submarine commander had reasonable cause to claim losses related to a tax shelter and thus was entitled to avoid paying accuracy-related penalties. The court determined that McNeill has carried his burden of proof to avoid accuracy-related penalties by reasonably relying on various written and oral advices he sought from highly qualified tax advisors, including from a highly respected accounting, consulting and law firms before he entered into a questionable distressed asset/debt (DAD) tax shelter transaction. Such a transaction generated a $20 million loss that allowed him to avoid payment of tax on the $18 million severance payment received after he retired from a position of chairman of the Board and co-CEO of Exelon Corporation, the energy provider company.

After retiring from the U.S. Navy, Mr. McNeill, pursued a career and became a president and later a CEO of PECO Energy. When PECO merged with Exelon Corporation, Mr. McNeill became a Chairman of the Board and co-CEO of Exelon. Upon reaching retirement, Mr. McNeill had accumulated considerable wealth. As part of his income tax and wealth management planning, he worked with the law firm of DeCastro, West, Chodorow, Glickfeld & Nass (DeCastro), and accounting firms Ernst & Young (E&Y) and BDO, as well as a well-known investment management consulting firm, Gramercy Advisors in attempt to manage his wealth and minimize payment tax liability or defer payment of tax from the current year to the future year.

As part of his wealth management plan, in 2002, the taxpayer engaged in what the court determined to be an abusive tax shelter, more specifically DAD tax shelter in the form of a distressed Brazilian debt investments. The tax advisors established a series of partnerships in which Brazilian debt holders contributed their distressed debt instruments and Mr. McNeill contributed relatively small sums of money into the DAD. Eventually, one of the partnerships would sell the distressed debt and generate a loss (paper loss) that was never actually suffered in economic terms, the loss would then offset the $18 million worth of income that McNeill received in tax year 2002.  

Throughout the process of structuring the transaction, McNeill asked for written opinions from all of the above mentioned highly qualified and well regarded professionals about the legitimacy of the investment. McNeill even asked for a legal opinion from DeCastro law firm that concluded that the transaction was in compliance with the Internal Revenue Code. None of the multiple tax advisors involved in structuring of the transaction ever advised Mr. McNeill that taking a $20 million loss on his 2002 return was illegal or against the tax code. The advice provided to Mr. McNeill did not discuss the step transaction doctrine, the economic substance doctrine or any of the anti-abuse doctrines or procedures.

Notwithstanding the efforts of BDO, Gramercy, DeCastro and E&Y, the DAD transaction did not withstand IRS's scrutiny. In 2006, the IRS determined that the transaction was an abusive tax shelter, denied the losses claimed and assessed accuracy-related penalties and interest totaling roughly $4.5 million. Mr. McNeill paid the liability and filed a claim for refund arguing that the penalties and interest should not apply based on reasonable cause because he reasonably relied in good faith on the professional opinions and actions of competent tax and legal advisors.

In evaluating the taxpayer’s reasonable cause argument, the court first focused on whether the taxpayer was knowledgeable or educated about tax strategies similar to that at issue. It was clear to the court that no advisor reasonably and fairly alerted the taxpayer about the importance of a profit motive, business purpose, and economic substance underlying the partnership and DAD transaction. The taxpayer’s focus was on other objectives he valued, including legal protection, diversification and tax deferral opportunities. The latter facts supported the taxpayer’s contention that he was neither knowledgeable nor educated about the complex tax strategy transactions.

However, the court recognized that the taxpayer was a sophisticated and very accomplished businessman. Throughout his time in business, the taxpayer gained experience with distressed debt unrelated to the DAD transaction. Nonetheless, the court noted that the taxpayer did not appear to have been sophisticated in terms of a contribution of debt to a partnership of a foreign entity, and the acquisition of partnership interest. While unquestionably accomplished in his own right, Mr. McNeill was not knowledgeable or sophisticated in the context of a complex DAD shelter or something similar.

Next, the court analyzed Mr. McNeill’s efforts towards determining their proper tax liability and whether those efforts were reasonable. In its analysis, the court focused on the fact that Mr. McNeill sought and obtained a positive, independent opinion from a qualified advisor, E&Y, about the entity that promoted the strategy and the strategy investment manager. Additionally, Mr. McNeill sought tax advice and received two separate unequivocally positive indicators from qualified tax professionals at E&Y that the tax strategy ‘worked,’ in that the anticipated tax loss from the strategy was compliant and lawful under the partnership code sections. Accordingly, the court determined that Mr. McNeill’s efforts to evaluate the proper tax liability were reasonable under the circumstances.

Finally, the court turned its attention to the reasonableness of Mr. McNeill’s reliance on the tax advice. In its analysis, the court pointed out that Mr. McNeill is not required to second-guess qualified, apparently independent and objective professionals whose advice, in retrospect, might have turned out to be incorrect. Here, the court determined, the taxpayer properly turned to qualified professionals that he trusted, told them what his purposes were and what he knew, provided the documents that he had. According to the court, the taxpayer engaged in sufficient due diligence with respect to the reasonableness of his reliance.

In addition, the court stated that the transaction was not a ‘too good to be true’ type of a transaction. The partnership rules that existed in 2002 contained a loophole that offered huge tax advantages to those who purchased interests in a partnership that owned property, as opposed to purchasing the property directly. The court cited Southgate Master Fund LLC ex rel. Montgomery Capital Advisors, LLC, 659 F.3d 466, (5th Cir. 2011) for a more thorough description of these types of taxpayer-friendly transactions. The court believed that Mr. McNeill’s tax advisors wanted to structure the transaction at issue in compliance with those partnership provisions that existed in 2002. What prevented them from accomplishing their goal were various judicial doctrines, including the economic substance doctrine, sham partnership doctrine and doctrine of substance over form that the IRS used to deny the claimed losses.

Conclusion and takeaways

The penalty that was at issue in this case was the accuracy-related penalty under section 6662. Section 6664(c)(1) provides, that the accuracy-related penalty shall not be imposed if the taxpayer establishes there was reasonable cause for the position that resulted in the penalty and the taxpayer acted in good faith in taking that position. See also Reg. section 1.6664-4(b)(1). The burden of proof is on the taxpayer to show that he/she acted with reasonable cause and in good faith.

Reg. section 1.6664-4(b)(1) states that reliance on professional advice constitutes reasonable cause when in the reliance was in good faith and, based on circumstances of any particular case, was reasonable.

There are certain requirements in the regulations that establish reliance:

  • Facts and circumstances test. The taxpayer must show that advice was based on all the pertinent facts and circumstances and the law as it relates to those facts and circumstances.
  • Advice must not be based on any unreasonable factual or legal assumptions and must not unreasonably rely on representations, statements, findings, or agreements of the taxpayer or any other person.
  • The taxpayer’s reliance on the advice must itself be objectively reasonable. For example, reliance on ‘too good to be true’ type of advice is not considered to  be reasonable.

The existence of reasonable cause as a defense to the accuracy-related penalty, is dependent upon the facts surrounding the advice, the advisors, the taxpayer’s knowledge and experience, the taxpayer’s provision of all factual detail to the advisors and the reasonableness of the taxpayer’s reliance on the advice. The taxpayer’s win in this case is limited to the facts determined by the court and thus, provides no  guarantee of a similar outcome to other taxpayers. However, it is a significant taxpayer win adding to the body of case law regarding the reasonable cause defense to the accuracy-related penalty.  

This outcome in the District Court is likely to be appealed by the government because the transaction is considered to be an abusive tax shelter. At the same time the District Court’s analysis may provide a strong foundation that the government must overcome to reverse the decision. Undoubtedly, the court found Mr. McNeill’s testimony to be credible and his reliance on the advice or his advisors to be reasonable. We await further consideration by the appellate court, should the government appeal the decision.

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