IRS Goes After Law Firm for Tax Shelter Transactions, Assesses Over $11 Million in Penalties

(Parker Tax Publishing November 6, 2015)

The IRS assessed $11.28 million in fines under Code Sec. 6708 for a law firm's failure to register transactions the IRS deemed were tax shelters, and to turn over a list of participants. A district court needed additional fact finding to determine whether the fines were excessive and whether the firm had reasonable cause to withhold the list and, thus, judgment could not be entered at this stage. Callister Nebeker & McCullough v. U.S., 2015 PTC 365 (D. Utah 2015).

According to the IRS, in 2001, certain attorneys with the law firm of Callister Nebeker & McCullough (CNM) began to promote a tax avoidance scheme designed to shelter certain clients' business income from tax through the acceleration of deductions for employer contributions to certain compensation plans. CNM's 2001 "scheme," the IRS said, involved contributions to nonqualified deferred compensation plans (NQDCPs). In 2004, after the IRS issued a new regulation targeting abuses arising out of transactions similar to the 2001 scheme, CNM implemented what the IRS deemed an "unwinding scheme" for clients (individual business owners).

According to the IRS, the unwinding scheme created a potentially abusive tax shelter that triggered reporting and disclosure obligations under Code Secs. 6111 and 6112. Under Section 6111, a tax shelter organizer must register the tax shelter with the IRS. Failure to do so results in penalties under Code Sec. 6707. In addition, Code Sec. 6112 requires a tax shelter organizer to maintain a list of participants in any potentially abusive tax shelter and to provide that list to the IRS upon request. Failure to do so results in penalties under Code Sec. 6708, unless the tax shelter organizer establishes reasonable cause for the failure.

Part of the unwinding process caught the IRS's attention and the IRS demanded that CNM disclose a list of the participants in the transactions. CNM refused. As a result, in 2010, the IRS assessed two penalties against the law firm: $195,081 for violating Code Sec. 6707 (i.e., failing to furnish information regarding reportable transactions); and $11.28 million for violating Code Sec. 6708 (i.e., failing to maintain lists of advisees with respect to reportable transactions).

CNM said it was not obligated to disclose the requested information because it was not a "tax shelter organizer" and because the unwinding scheme was not a "potentially abusive tax shelter." Alternatively, CNM argued that even if the transaction implementing the unwinding scheme fell within the statutory definition of a "potentially abusive tax shelter," CNM was not required to produce the requested information because doing so would violate attorney-client privilege under the Utah Rules of Professional Conduct. According to CNM, it refused to provide the list of participants based on advice of counsel, and cited the "reasonable cause exception" in Code Sec. 6708, which, if satisfied, would allow CNM to escape the disclosure requirements and penalties.

CNM filed a motion for judgment with a Utah district court. CNM requested, among other things a finding that the IRS's assessment of the $11.28 million penalty was an abuse of discretion and was an unconstitutionally excessive fine under the Eighth Amendment. CNM asserted that the IRS's admissions to allegations in the documents filed with the court established ample, undisputed facts to decide the issues as a matter of law.

The District Court noted that Code Sec. 6111 defines "tax shelter" as any investment 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 may be greater than 2 to 1 and is "substantial." The "reasonably infer" test, the court said, and calculation of the "tax shelter ratio" were key to determining whether the transactions by CNM's clients should have been registered as tax shelters. The court agreed with the IRS that the phrase "any person could reasonably infer" required a factual determination of fact. The court also agreed with the IRS that the "reasonable cause" exception to the penalties assessed against CNM required a fact intensive determination that could not be hashed out in CNM's motion for judgment.

The court also stated that whether the Eighth Amendment applied required it to determine whether the Code Sec. 6708 penalty was punitive (which required an assessment of the penalty imposed and its purpose), and for it to consider whether the penalty was excessive. The court noted it could not decide at the time whether the $11.28 million fine was excessive, because it needed a fully developed record to determine whether the fine was proportionate to the gravity of the offense.

For a discussion of the penalties associated with tax shelters, see Parker Tax ¶253,170. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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