DON'T LET THE PROMOTERS CONVINCE YOU TO "DEFEND THE TRANSACTION" WHILE THE STATUTE OF LIMITATIONS CUTS OFF YOUR RIGHT TO SUE THEM FOR DAMAGES
Once again, tax shelter promoters have re-named, re-packaged, and combined some old and recognizably illegal and abusive tax shelters in order to defraud a new set of unsuspecting taxpayers. The so-called “Syndicated Conservation Easement” tax shelter is the latest example. The Syndicated Conservation Easement is designated as an “Listed Transaction” pursuant to IRS Notice 2017-10. This means, in plain-speak, that once (not if) the IRS becomes aware that you asserted tax deductions from a Syndicated Conservation Easement tax strategy, the IRS will be looking for you to pay back taxes, interest, and a penalty. If you were sold one of these Easement strategies, you should be looking into the possibility of a malpractice and fraud case against the promoters. Here’s why.
THE SYNDICATED CONSERVATION EASEMENT SHELTER IS A RE-TREAD AND VARIANT OF TWO TAX SHELTERS PREVIOUSLY REJECTED BY THE IRS
First, the IRS is taking aggressive action to identify and disallow any benefits claimed by a taxpayer that participated in a Syndicated Conservation Easement. The IRS will find you by simply issuing subpoenas to the promoters that sold the Easement to you. And don’t let any promoter tell you otherwise, nearly every major player (accountants, banks, law firms) in the tax shelter business lost the “fight the subpoena” in the tax shelter cases that ensued over 1999 – 2005. In those cases, many tax shelter promoters advised their clients to play the “audit lottery” and not divulge their participation in the tax shelters at issue. This proved to be a very expensive and bad gamble for those taxpayers. The IRS figured out who the involved taxpayers were, and, often, by the time that happened, the taxpayers had not sued the promoters civilly and the statutes of limitations had run.
Second, the Syndicated Conservation Easement is really nothing more than a play on the previously failed and rejected “tax strategies” known as the SC2 or “S-Corp Charitable Contribution Strategy” and the “DAD” or “Distressed Asset/Debt” strategy from fifteen years ago.
THE SC2 OR S-CORP CHARITABLE CONTRIBUTION STRATEGY: THE OLD CHARITABLE CONTRIBUTION PLAY
The SC2 strategy, rolled out by two partners in KPMG’s Los Angeles’ office, promised to shave millions of dollars off the personal tax bills of wealthy business owners. The goal of SC2 was to turn personal income from an S corporation - shareholder profits – into long-term capital gains, which were taxed at a much lower rate. The method devised by KPMG was for an S Corporation to issue nonvoting stock, donate it to a tax-exempt entity and then buy it back after a couple of years – time enough to qualify the re-purchased stock as “long-term” under the tax code.
To further explain, suppose an S Corporation has 100 shares. Under the SC2 plan, it issues 900 new, nonvoting shares and donates them to a tax-exempt institution, generating a charitable tax deduction for the corporate shareholders. While the stock is in its possession, the institution is entitled to 90% of the company’s profits, but in most cases the cash is not distributed but allowed to build up within the company. And because it is tax-exempt, the institution pays no income taxes on its share of the accrued profits.
The original shareholders, meanwhile, must keep paying taxes. But because they now own only 10% of the company -- although all of its voting stock, thereby retaining actual control -- they pay just one-tenth of the income taxes they otherwise would owe. After two or three years, the tax-exempt entity sells the stock back to the original shareholders. The original shareholders now must pay taxes on all the retained profits, but at the lower, capital-gains rate.
For a variety of reasons, the SC2 strategy didn’t “work.” In 2004, the IRS denominated the “S-Corporation Tax Shelter” as a “listed transaction” pursuant to IRS Notice 2004-30. To invalidate the shelter, the IRS relied on a series of well-worn court doctrines such as “substance over form” and the “step-transaction” doctrine (both mean what they imply). Moreover, the IRS argued that a warrant feature contained in SC2 violated the S-Corporation “single class of stock requirement.” The SC2 promoters repeatedly asserted the bona fides of SC2 and encouraged their clients to avoid IRS settlement offers and to instead fight the IRS in Tax Court. You should not be surprised to hear that the SC2 shelter clients that elected to “defend” SC2 lost over and again. And, quite often, the same shelter clients waited too long to sue the tax shelter promoters, and later found out they were “timed out” by state statutes of limitation.
“DAD” OR “DISTRESSED ASSET/DEBT” STRATEGY: LET’S BUY SOME (INTENTIONALLY) WORTHLESS DEBT AND THEN TAKE A LOSS ON IT
The tax shelter known as the “distressed asset/debt (‘DAD’)” transaction is one where a taxpayer acquires a large built-in loss from a foreign entity to shelter unrelated U.S. income. In this shelter, a foreign (or other tax-indifferent) entity contributes distressed assets (i.e., property in which the asset’s basis grossly exceeds its value, thus producing a large built-in loss – such as bad debt) to a partnership. Shortly thereafter, a U.S. taxpayer purchases the foreign entity’s partnership interest (or a portion thereof). The partnership then sells the distressed assets and purportedly "realizes" an enormous tax loss. The vast majority of the loss is passed through the partnership to an individual U.S. taxpayer, who uses it to offset unrelated U.S. income. In this manner, an economic loss incurred by the foreign entity is separated from the tax loss (which the foreign entity cannot use), which is claimed by a U.S. taxpayer who incurred no or minimal economic loss.
Under the Code’s partnership rules, if a partnership sells an asset with a built-in loss, that loss cannot be shared with all the partners but is instead allocated to the partner that contributed the asset. In this way, the Code prevents one taxpayer from transferring tax benefits to another taxpayer. Under the rules that existed in 2002, if a partner transferred his partnership interest to a new partner before the asset was sold, then the built-in loss could be allocated to the transferee partner. In 2004, however, Congress amended the partnership rules to prevent taxpayers from shifting built-in losses from tax indifferent parties to U.S. taxpayers through the use of a partnership. After the amendments, such built-in losses could be taken only by the contributing partner, except for very limited amounts (less than $250,000).
These changes in U.S. tax law did not deter the promoters of the Distressed Asset Tax Shelter (“DAD”). One set of DAD promoters decided to use Chinese non-performing loans ("NPLs") to create artificial losses for the ultimate use of U.S. taxpayers. For many years, Chinese state-owned banks had generated large numbers of NPLs by “loaning” money to state-owned enterprises without any reasonable expectation of repayment. In 1999, China created four state-owned Asset Management Companies ("AMC") to assist the failing banks. The AMCs were required by Chinese law to buy the banks’ NPLs at face value even though they were worth far less than that amount. These AMCs would later comprise the NPLs hat would "power" the DAD tax shelter transaction. The non-performing loans that the tax shelter promoters acquired from the Chinese AMCs were classified as “lowest priority loans,” which meant that there was “little hope to get the loans paid back.” As a result, of course, the promoters were able to purchase these Chinese NPLs at an enormous discount to their face value.
The promoters pitch to their clients centered on the false factual assertion that the distressed debt had a value for federal tax purposes equal to its original face value. (Again, in reality, the promoters paid a fraction of the face value to purchase the bad Chinese debt, say 1 to 2 percent.) To give this assertion factual “heft,” the promoters obtained seemingly bona fide appraisals of the debt from seemingly legitimate appraisal services. In reality, the appraisal service ad been promised a “cut” of the tax shelter profits, in exchange for a “friendly” appraisal opinion (put otherwise, the appraiser became one of the promoters, albeit a hidden one). The promoters then passed the "appraised" debt through a series of trusts, and then sold those debt-holding trusts to their clients for a price pegged to the tax loss to be generated by the tax shelter. Shortly thereafter, the promoters arranged for the tax shelter trusts to sell the distressed assets (for their real close to “zero” value) to an accommodating party in order to realize an enormous tax loss. The vast majority of this loss as thereafter passed through to the U.S. taxpayer, who then used he loss to offset his or her unrelated U.S. income. In this way, an economic loss incurred by a foreign entity was separated from the tax loss (which the foreign entity cannot use), and was then claimed by a U.S. taxpayer who incurred no or minimal economic loss.
Not surprisingly, the pre-planned series of steps and the resultant tax losses from the DAD tax shelter ran afoul of well-settled U.S. law. The taxpayer’s partnership vehicle was used solely to generate tax losses, lacked "economic substance," and thereby constituted a sham in the eyes of the IRS. The partnership also violated “substance over form” and “step transaction” principles due to its pre-arrived tax sheltering plan and the series of contrived contributions and transfers that accompanied it. At bottom, the whole thing was merely a scheme to manipulate IRS partnership rules to transfer high-basis/low-value assets from an entity that could not use the built-in loss to a taxpayer who could. U.S. courts ultimately sided with the IRS and marked the DAD shelter as an illegitimate sham. At great cost and pain to the taxpayers who invested In it.
THE SYNDICATED CONSERVATION EASEMENT FAILS FOR THE SAME REASONS SC2 AND DAD FAILED – IT IS A SHAM TAX SHELTER DEVOID OF ECONOMIC SUBSTANCE
Through the “Syndicated Conservation Easement” tax strategy, shelter promoters claim syndicated conservation easement transactions give investors an opportunity to claim charitable contribution deductions (as in SC2) in amounts that significantly exceed the amount invested (much like the “opportunity” in the DAD shelter to obtain the high-basis/low-value debt later used to generate tax losses). In such a syndicated conservation easement transaction, the promoter offers prospective investors in a partnership or other pass-through entity the possibility of a charitable contribution deduction for donation of a conservation easement.
The promoters (i) identify a pass-through entity that owns real property, or (ii) form a pass-through entity to acquire real property. Additional tiers of pass-through entities may be formed. The promoters then syndicate ownership interests in the pass-through entity that owns the real property, or in one or more of the tiers of pass-through entities, using promotional materials that suggest to prospective investors that an investor may be entitled to a share of a charitable contribution deduction that equals or exceeds an amount that is two and one-half times the amount of the investor’s investment. The promoters obtain an appraisal that purports to be a qualified appraisal as defined in IRS Code § 170(f)(11)(E)(i) but that greatly inflates the value of the conservation easement based on unreasonable conclusions about the development potential of the real property (again, much like in the DAD shelter). The investor is not typically informed by the promoter that the appraiser is in league with the promoters, and therefore the appraisal is not “independent,” nor is it “bona fide,” and it cannot be relied upon.
After the conservation easement investor invests in the pass-through entity, either directly or through one or more tiers of pass-through entities, the pass-through entity donates a conservation easement encumbering the property to a tax-exempt entity (again like the tax indifferent and accommodating parties in SC2 and DAD). Investors who held their direct or indirect interests in the pass-through entity for one year or less purport to rely on the pass-through entity’s holding period in the underlying real property to treat the donated conservation easement as long-term capital gain property under IRS Code § 170(e)(1). The promoter receives a fee or other consideration with respect to the promotion, which may be in the form of an interest in the pass-through entity.
The IRS challenges the purported tax benefits from this transaction based on the overvaluation of the conservation easement. The IRS also challenges the purported tax benefits from this transaction based on the partnership anti-abuse rule, economic substance, the step transaction rule, or other similar rules or doctrines.
In many cases, the promoter obtains a tax shelter opinion letter for the investor from an accountant or lawyer to support the tax treatment of the transaction, for the ostensible purpose of protecting the taxpayer from penalties in the event the IRS (successfully) disallows the tax shelter. However, in almost every case, and under the U.S. law, the opinion letter writer is compensated from the tax shelter proceeds themselves, and/or is affiliated with the tax shelter promoters, and, therefore, the opinion letter writer is conflicted, and cannot author a proper “penalty protection” tax opinion.
Like so many tax shelters, the investor is not told the "real" facts surrounding their tax shelters – almost all tax shelter investors are honest taxpayers seeking a way to legally minimize their tax liability. Regardless of the complexity of the tax code, however, it is not hard to understand that contrived transactions, comprised of fake debt or built upon inflated appraisals, without any real objective opportunity for profit, will almost certainly be disallowed by the IRS, and will almost always ultimately be deemed shams without economic substance by U.S. courts. Anyone who tells you otherwise should be viewed with great skepticism.
And if the same promoters are discouraging you from seeking litigation counsel, while encouraging you to fight the IRS in court to prove the legitimacy of the tax shelter – look out. This is the same primrose path laid out by the promoters during the Son of BOSS, FLIP, BLIPS, and POPS years. The promoter's hope is that by the time the IRS beats you in court, the opportunity to sue the promoter for malpractice or fraud will have long since been extinguished by state statutes of limitation.
EXPERIENCED ABUSIVE TAX SHELTER REPRESENTATION
Gary Mauney of Mauney PLLC has almost two decades of experience representing tax shelter investors across the United States in civil malpractice and fraud litigation against tax shelter promoters, such as accountants, attorneys, banks, and other financial advisors. Gary's knowledge about tax shelter litigation has been featured in prominent books on the subject, and in newspapers like The New York Times and The Wall Street Journal. Gary has written and taught extensively on the subject of tax shelter lawsuits and litigation, including in The Journal of Taxation and Regulation of Financial Institutions and the American Trial Lawyer's Association.
If you invested in what might be an unlawful or abusive tax shelter, do not sit back and wait for the IRS to come calling and hope for the best. Time is not on your side. The amount you paid the promoters, the amount of your investment, and IRS penalties and interest, are losses to which you are exposed. Statutes of limitation running in favor of the tax shelter promoters apply in virtually every state and may quickly cut off your right to sue. Crucial evidence concerning your transaction may be "lost" or may "disappear" as document retention "policies" are applied by the promoters. If you think you might have invested in an abusive tax shelter, contact Gary Mauney at Mauney PLLC for a confidential and privileged consultation regarding your options. Please send a confidential email to Mauney PLLC at info@mauneypllc.com. Or call attorney Gary Mauney directly at 704/945-7185.