Judge Kroupa tells the sad story of the orphan boy who makes his fortune, only to be led astray (he claims) by a “Big Four” accounting firm, at the end of whose rainbow was no pot of gold. The rainbow is the so-called OPIS (Offshore Portfolio Investment Strategy), this being Tax Court’s first encounter with this convoluted tax dodge.
The tale unfolds in Scott A. and Audrey R. Blum, 2012 T.C. Mem. 17, filed 1/17/12.
Judge Kroupa sets the scene: Scotty “the only adopted child of an engineer and a secretary, was an entrepreneurial child and prone to selling his toys. After parking cars for a hotel and selling women’s shoes, he started his first company when he was 19 years old to sell computer memory products. He sold that company two years later for over $2 million. During the same year, at the age of 21, Mr. Blum started Pinnacle Micro, Inc. (Pinnacle) with his parents. Mr. Blum and his parents ran Pinnacle for nine years, including when it was a public company. Mr. Blum entered into an Internet-based business after leaving Pinnacle.
“Mr. Blum founded Buy.com, an online retailer, in 1997, and it set a record for being the fastest growing company in United States history during its first year of operation. In . . . Mr. Blum sold a minority interest in Buy.com stock for a total of $45 million. The sales comprised a $5 million stock sale in August and a $40 million stock sale at the end of September. His basis in the stock was zero, and in response to the potential gain Mr. Blum entered into a $45 million OPIS transaction during . . . , creating a capital loss of approximately $45 million. The OPIS transaction was created, managed and promoted by Mr. Blum’s accounting firm.” 2012 T. C. Mem. 17, at pp. 3-4.
Scotty needed to offset his gain. The accountants set up a three-tier collar on the Swiss Franc, packing UBS stock into the mix, to make sure that the deal Bialystoked (homage to the late great Zero Mostel in the original Producers) on schedule.
New verb: to “Bialystok” is to guarantee that a transaction is an economic disaster on paper, generates huge tax loss for little cash, and provides the promoters thereof with a “get into jail free” card.
Scotty of course got no private placement memo, never did the math on the deal, had one two-hour meeting with the accounting firm’s salesman (after which he spoke to that person once by telephone as the deal was going down), and had no idea what the accounting wizards were doing.
If wheeling and dealing strokes your shell, you can read as Judge Kroupa scoots down the rainbow, plows through Cayman Islands exempted companies, Isle of Mann (so in original; apparently neither the attorneys nor Judge Kroupa’s clerk was too hot on spelling or geography) corporations, and Cayman Islands limited partnerships, and finds the pot, but no gold, at the end thereof. “At the conclusion of this convoluted and contrived series of transactions, the net cost of the OPIS transaction to Mr. Blum was approximately $1.5 million. For that cost, the OPIS transaction yielded over $45 million in capital losses to offset capital gains on tax returns petitioners filed.” 2012 T.C. Mem. 17, at p. 17.
Judge Kroupa has to draw a diagram to show how the deal worked, which see, on page 18 of her decision. If Eli Manning runs this against the Niners on Sunday, the Giants might just win it all.
“The . . . engagement letter stated that . . . would provide a tax opinion letter regarding the OPIS transaction, if requested.[. . . ] sent to Mr. Blum a letter, dated after petitioners filed an income tax return for . . ., asking Mr. Blum to represent certain information about the OPIS transaction. [. . . ] agreed to finalize and issue its tax opinion after receiving the signed representation letter. Mr. Blum signed the representation letter in May . . .. In that letter, Mr. Blum represented that he had independently reviewed the economics underlying the investment strategy and believed it had a reasonable opportunity to earn a reasonable pre-tax profit. He made this representation even though he had not performed an economic analysis of the transaction or consulted with his investment advisers about the transaction.” 2012 T.C. Mem 17, at pp. 19-20 [Names and dates omitted].
You can guess the rest. IRS comes down on these shenanigans like the Assyrian wolf on the fold, and strips Scotty and his cohorts of silver and gold. The accounting firm makes a plea bargain. Some of its employees, agents and servants, alleged perpetrators of this raid on the Treasury, are pursued by agents of the Fisc over hill, over dale.
Not a whit dismayed, Scotty sues his erstwhile accountants, claiming they deceived him and now IRS wants to denude him, a poor orphan, of his American Dream. He’s an injured innocent.
No, says Judge Kroupa, the whole deal was bogus, despite the accountants’ mix-and-match games with IRC. “We agree with respondent (IRS) that the OPIS transaction lacked economic substance. We admit [. . . ] painstakingly structured an elaborate transaction with extensive citations to complex Federal tax provisions. The entire series of steps, however, was a subterfuge to orchestrate a capital loss. A taxpayer may not deduct losses resulting from a transaction that lacks economic substance, even if that transaction complies with the literal terms of the Code.” 2012 T. C. Mem. 17, at p. 27 (Citations and names omitted).
Economic substance means matching tax losses with economic losses. But note that Congress’ codification of economic substance in the Health Care and Education Reconciliation Act of 2010 is not retroactive, so it plays no role here, 2012 T.C. Mem. 17, at p. 28, footnote 21.
So Judge Kroupa is back to the caselaw. “A court may disregard a transaction for Federal income tax purposes under the economic substance doctrine if it finds that the taxpayer failed to enter into the transaction for a valid business purpose but rather sought to claim tax benefits not contemplated by a reasonable application of the language and purpose of the Code or its regulations. There is, however, a split among the Courts of Appeals as to the application of the economic substance doctrine. An appeal in this case would lie to the Court of Appeals for the Tenth Circuit absent stipulation to the contrary and, accordingly, we follow the law of that circuit.
“The Court of Appeals for the Tenth Circuit applies a socalled unitary analysis in which it considers both the taxpayer’s subjective business motivation and the objective economic substance of the transactions. The presence of some profit potential does not necessitate a finding that the transaction has economic substance. Instead, that Court of Appeals requires that tax advantages be linked to actual losses. It has further reasoned that ‘correlation of losses to tax needs coupled with a general indifference to, or absence of, economic profits may reflect a lack of economic substance’.” 2012 T. C. Mem. 17, at pp. 28-29 (Citations and footnotes omitted).
A true Bialystok (noun form of verb) is generally indifferent to economic profits, and makes sure they are absent.
Judge Kroupa blows off Scotty’s trial testimony that he wanted to make money, and that his accountants sold him to the Swiss-Cayman-Manx con-artists. “Mr. Blum testified that $5 million was a relatively sizable amount of money to him. The record indicates that Mr. Blum essentially entrusted this sizable amount of money to an unknown investment adviser based on two hour-long presentations from his tax adviser. Mr. Blum did not perform an economic analysis of the OPIS transaction, nor did he ask his existing investment advisers to review it. He had no general knowledge of the participants (except for . . . and UBS) and no understanding of the transaction. Furthermore, Mr. Blum did not track his investment, except to the extent that he received a call from . . . a month into the deal.
“Mr. Blum’s actions belie his testimony. His lack of due diligence in researching the OPIS transaction indicates that he knew he was purchasing a tax loss rather than entering into a legitimate investment.” 2012 T. C. Mem. 17, at p. 32. (Names omitted)
Likewise Scotty’s averments in his lawsuit against his erstwhile chums are at odds with his claims of innocence. “In his suit, Mr. Blum alleges that he was induced to invest millions of dollars in a tax strategy and to conduct his business so as to realize taxable income that would be offset by losses generated by OPIS. He further claims that, in reliance on . . . , he did not adopt other strategies to defer or minimize his tax liability or make different decisions regarding share sales. Mr. Blum’s actions during and after the OPIS transaction do not indicate a profit motive.” 2012 T. C. Mem., at pp. 32-33.
No profit, no economic substance. Judge Kroupa boils it all down in a heading: “E. The Numbers Do Not Add Up.” 2012 T. C. Mem. 17, at p. 35.
But the penalties do. And because Scotty said he reviewed the deal and sussed it out, when he had done no such thing, he hadn’t told his accountants the truth, so he couldn’t rely on their tax opinion (which was based on his representation that he had). And anyway, they were promoters. So negligence with gross undervaluation (40% of tax due) rains down on Scotty. And Scotty, a “savvy, experienced businessman” as Judge Kroupa calls him, 2012 T. C. Mem. 17, at p. 46, should know that when a deal sounds too good to be true, it probably is, and he should check it out with people who have no piece of the action. So the good faith reliance on experts defense is out.