Son of Boss Case Shows Limitations of Reliance on Tax Advisors to Avoid Penalty

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Son of Boss cases seem to go on forever. In Palm Canyon X Investments, LLC, AH Investment Holdings, LLC, Tax Matters Partner v. Commissioner, No. 16-1334 (D.C. Cir. Feb. 16, 2018), the D.C. Circuit affirmed with a per curiam opinion the decision of the Tax Court to sustain the 40% penalty imposed under IRC 6662 for a 400% misstatement of basis. The case does not break new ground but does serve as a reminder of the limitation of the defense of reliance on counsel.

The taxpayer raised as a defense the existence of reasonable cause citing IRC 6664(c)(1). The basis asserted for the reasonable cause grounded in reasonable reliance on the advice of a “competent and independent professional advisor.” We have written recently, here and here, on the perils of using an expert witness who did not have sufficient independence from the transaction. Today’s case demonstrates the same problem when relying on a professional to avoid an otherwise applicable penalty. In the Palm Canyon case, the taxpayer not only relied on professionals who lacked independence but failed to rely on professionals who did. The existence of the case points to the high dollars at stake in the penalty and the wealth of the taxpayer to push the fight this far.

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The Son of Boss tax shelter came into existence over two decades ago. It involved artificially inflating basis in a partnership interest in order to get a tax write-off for artificial losses created upon dissolution. The D.C. Circuit cited to a 20 year old decision invalidating a transaction based on this scheme. So many people invested in the scheme that the IRS issued Notice 2000-44 specifically warning taxpayers that the use of this scheme could result in the imposition of the type of heavy penalty at issue here. By the time it issued this Notice, several cases already existed sustaining the legal position of the IRS.

The taxpayer here went looking for a tax shelter in 2001. The taxpayer had an accountant and a lawyer. These individuals looked at the Son of Boss tax shelter offered to their client and advised him that the generic tax opinion provided by the shelter promoter was “aggressive.” The D.C. Circuit’s opinion does not say whether they provided the taxpayer with a copy of the IRS Notice or copies of the cases that had already determined this type of shelter would not work. The taxpayer decided to purchase the shelter and paid a $325,000 fee for doing so. He claimed a $5,000,000 loss reducing his tax liability from $1,500,000 to nothing which would have been a great bargain had the IRS not disallowed the loss in full and imposed the 40% penalty.

At the circuit court level, the taxpayer did not dispute the unlawful nature of the transaction but argued only that the reliance on the lawyers and the tax advisors who prepared their advice for those selling the scheme provided a basis for removing the penalty for reasonable cause. The court quickly went through five reasons why the taxpayer could not succeed with a reasonable cause argument.

First, the Notice issued by the IRS expressly warned against doing what he did and did so over a year before he bought into the scheme. The existence of the notice “makes proof of reasonableness in this case an especially steep uphill battle.”

Second, the taxpayer’s reliance on the advice of individuals connected with the promotion of the scheme is “objectively unreasonable.”

Third, the taxpayer could not rely on the advice of his accountant whose role here was to investigate the bona fides of the promoter and not to provide tax advice. Additionally, to the extent that the taxpayer’s accountant did provide tax advice it was that the claimed benefits of the scheme were “too good to be true.”

Fourth, the taxpayer could not rely on the advice of his own lawyer as a shield from the penalty because his lawyer was skeptical of the transaction. Like the accountant, the taxpayer’s lawyer limited his due diligence to the scheme’s players and not to the substance of the transaction.

Fifth, the tax opinions provided by the promoters did not pass muster. The opinions were not based on “all pertinent facts and circumstances” relating to the taxpayer, and the parties giving the opinions were part of the promotion team.

Perhaps the only surprises in this opinion are that the taxpayer bought the shelter in the first place, given the information about the scheme available at the time of purchase, and that 17 years later he is still fighting about the penalty when the denial of penalty relief here follows consistent patterns of prior opinions on this subject. While it’s easy to be dismissive of the case, this is a sophisticated taxpayer. The case not only provides guidance on when a taxpayer cannot rely on professional advice to avoid a penalty but insight on the power of pull of the tax shelter scheme that it would motivate someone to fight this long after the conclusion of the transaction and in the face of high odds.

 

Comments

  1. Carl Smith says:

    For a similar result in a similar shelter, see today’s RB-1 Investment Partners v. Commissioner, T.C. Memo. 2018-64, by Judge Holmes.

  2. I know that Keith Fogg is not trading on insider information, so it is just coincidence that his timely blog comments were posted shortly before today’s Tax Court opinion in another Son-of-BOSS penalty case (which was commenced in 2004). This opinion is easier to follow, because of Judge Holmes’ style. He doesn’t push the metaphors too far, but he begins with

    “The Reinhart brothers made a fortune when they sold their family concrete business in 2000, but the sale threatened a hefty tax liability.”

    and later includes

    “Before we pour the slab specific to RB-1’s reasonable-cause-and-good-faith defense, let us build the form.”

    https://www.ustaxcourt.gov/UstcDockInq/DocumentViewer.aspx?IndexID=7356696

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