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T.C. Memo. 1999-101
UNITED STATES TAX COURT
JERRY AND PATRICIA A. DIXON, ET AL.,1 Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent*
Docket Nos.
9382-83, 17646-83,
4201-84, 7323-84,
15907-84, 20119-84,
40159-84, 22783-85,
30010-85, 30979-85,
29643-86, 35608-86,
19464-92,
621-94,
7205-94, 9532-94,
17992-95, 17993-95.
Filed March 30, 1999.
1
Cases of the following petitioners are consolidated
herewith: Ronald L. Alverson and Mattie L. Alverson, docket No.
17646-83; Hoyt W. and Barbara D. Young, docket Nos. 4201-84,
22783-85, 30010-85; Anthony E. and Carol A. Eggers, docket No.
7323-84; Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84,
30979-85; John L. and Terry E. Huber, docket No. 20119-84;
Terry D. and Gloria K. Owens, docket No. 40159-84; Richard and
Fidella Hongsermeier, docket No. 29643-86; Norman W. and
Barbara L. Adair, docket No. 35608-86; Willis F. McComas, II and
Marie D. McComas, docket No. 19464-92; Wesley Armand and Sherry
Lynn Cacia Baughman, docket No. 621-94; Joe A. and JoAnne
Rinaldi, docket No. 7205-94; Norman A. and Irene Cerasoli, docket
No. 9532-94; Stanley C. and Sharon A. Titcomb, docket No. 1799295; Richard B. and Donna G. Rogers, docket No. 17993-95.
*
This opinion supplements our previously filed Memorandum
Findings of Fact and Opinion in Dixon v. Commissioner, T.C. Memo.
1991-614, vacated and remanded per curiam sub nom. DuFresne v.
Commissioner, 26 F.3d 105 (9th Cir. 1994).
- 2 In Dixon v. Commissioner, T.C. Memo. 1991-614,
vacated and remanded per curiam sub nom. DuFresne v.
Commissioner, 26 F.3d 105 (9th Cir. 1994), following a
trial of 14 docketed test cases of eight Ps, the Court
sustained R's disallowance of interest deductions
claimed by Ps in various tax shelter programs promoted
by K. After the Court entered decisions against the
test case Ps in accordance with its opinion, R moved to
vacate the decisions entered in three test cases (T, C,
and X). R alleged that, before the trial of the test
cases, R's trial attorney and District Counsel had
entered into contingent settlement agreements with T
and C that had not been disclosed to the Court or to
the other test case Ps or their counsel. R asked the
Court to conduct an evidentiary hearing to determine
whether the undisclosed agreements with T and C had
affected the trial of the test cases or the opinion of
the Court.
The Court granted R's motions to vacate the
decisions entered in the T and C cases, entered revised
decisions in the T and C cases consistent with R's
prior agreements with T and C, denied R's motion to
vacate the decision in the X case, and denied R's
request for an evidentiary hearing on the ground that
the testimony, stipulated facts, and exhibits relating
to the T and C cases had no material effect on the
Court's opinion as it related to the remaining test
case Ps.
On appeal, the Court of Appeals for the Ninth
Circuit vacated the decisions in the remaining test
cases and remanded them to this Court with directions
"to conduct an evidentiary hearing to determine the
full extent of the admitted wrong done by the
government trial lawyers." DuFresne v. Commissioner,
supra at 107. The Court of Appeals, citing Arizona v.
Fulminante, 499 U.S. 279, 309 (1991), directed the
Court to consider "whether the extent of misconduct
rises to the level of a structural defect voiding the
judgment as fundamentally unfair, or whether, despite
the government's misconduct, the judgment can be upheld
as harmless error." Id. Further, the Court of Appeals
directed this Court to consider on the merits all
motions of intervention filed by affected parties. See
id. This Court ordered that the cases of 10 nontest
case Ps, the majority of whom had previously signed
piggyback agreements, be consolidated with the
remaining test cases for purposes of the evidentiary
hearing. Three groups of Ps participated in all
subsequent phases of the evidentiary hearing.
- 3 Ps argue (under various theories) that the Court's
decisions in the remaining test cases should not be
reinstated, or, in the alternative, that the piggyback
agreements are not enforceable. R counters that the
decisions in the remaining test cases should be
reinstated on the ground that Ps were not prejudiced by
the Government misconduct in the trial of the test
cases and that the piggyback agreements remain in
force.
Held: The Government misconduct in the trial of
the test cases did not result in a structural defect in
the trial. Held further: The Government misconduct in
the trial of the test cases resulted in harmless error.
Held further: The Government misconduct in the trial
of the test cases does not provide any other basis for
invalidating the Court's decisions in the remaining
test cases or for setting aside the piggyback
agreements. Held further: As a sanction against R,
program participants who have not been the subject of a
final determination are not liable for time-sensitive
additions to tax for negligence under secs. 6653(a)(2)
and 6653(a)(1)(B), I.R.C., or increased interest under
sec. 6621(c), I.R.C.
Joe Alfred Izen, Jr., counsel for petitioners in docket Nos.
9382-83, 4201-84, 15907-84, 40159-84, 22783-85, 30010-85, 3097985, 29643-86, and 35608-86.
Robert Alan Jones, counsel for petitioners in docket Nos.
17646-83, 19464-92, 621-94, and 9532-94.
Robert Patrick Sticht, counsel for petitioners in docket
Nos. 7323-84, 20119-84, 7205-94, 17992-95, and 17993-95.
Mary Elizabeth Wynne, Steven A. Wilson, Andrew J. Gottlieb,
Milton J. Carter, Jr., Robert E. Casey, and Richard S. Goldstein,
for respondent.
- 4 CONTENTS
Page
Introduction....................................................9
FINDINGS OF FACT...............................................15
I.
Kersting Tax Shelter Programs and Related Matters........15
A. The Pike Case............................................15
B. Kersting Criminal Investigation..........................16
C. Assessments of Kersting Promoter Penalties...............18
D. Kersting Notice of Deficiency............................19
II.
Notices of Deficiency Issued to Kersting Program
Participants ............................................20
A. Form of Notices of Deficiency............................20
B. Thompson Notices of Deficiency...........................21
C. Cravens Notices of Deficiency............................23
D. Alexander Notices of Deficiency..........................24
1. 1974 and 1975.........................................25
2. 1976 and 1977.........................................26
E. Validity of Notices of Deficiency........................27
F. Errors in Notices of Deficiency..........................27
III. Commencement of Kersting Project ........................28
A. Tax Shelter Projects and Test Case Procedures............28
1. Overview..............................................28
2. National Office Tax Shelter Branch Functions..........30
B. Petitions for Redetermination............................31
C. Brian J. Seery...........................................32
D. Respondent's Counsel.....................................33
1. Kenneth W. McWade.....................................33
2. William A. Sims.......................................34
E. Adoption of Test Case Procedures in Kersting Project.....34
1. The Honolulu Session (June 1985)......................34
2. Test Case Procedure...................................35
3. Test Case Array.......................................38
IV.
The Maui Session (February 1987).........................42
A. Trial Notices............................................42
B. Piggyback Agreements.....................................44
C. Mr. Seery's Withdrawals as Counsel.......................48
1. The Thompsons.........................................49
2. The Test Cases........................................50
D. Entries of Appearance by Chicoine and Hallett............51
E. Evidentiary Issues.......................................54
1. The Maui Session......................................54
2. Dixon I Opinion.......................................55
V.
Kersting Disputes With Program Participants..............55
A. The Thompsons............................................56
- 5 1. The Bauspar Program...................................56
2. Deterioration of Thompson/Kersting Relationship.......57
B. The Alexander Dispute....................................67
C. Collection Actions.......................................72
1. Steve Hane............................................72
2. Carl Mott, George Vermef, and Robert Peterson.........73
VI.
Settlements..............................................74
A. Internal Revenue Service Policy..........................74
1. National Office Position..............................74
2. Regional Counsel......................................76
B. Official Kersting Project Settlement Offer (7-Percent
Reduction of Deficiency or Out-of-Pocket Expenses).......77
C. Deviations From Official Project Settlement Offer........78
1. Modified 7-Percent Settlement Offer...................78
2. 20-Percent Settlement Offer...........................80
3. Negotiations for 50-Percent Settlement Offer..........82
4. Revival of 20-Percent Settlement Offer................84
D. The Thompson Settlement..................................92
1. Initial Thompson Settlement Agreement.................92
2. First Revision of Thompson Settlement.................94
3. Second Revision of Thompson Settlement................98
E. The Cravens Settlement..................................100
F. The Alexander Understanding.............................106
G. The Kozak Decision......................................115
VII. Pretrial Developments...................................116
A. The Kersting Deposition--Postponed (January 1987).......116
B. John Doe Summons/Assessments of Promoter Penalties......118
C. Chicoine and Hallett's Withdrawal as Counsel............120
D. Mr. Izen's Entry of Appearance..........................120
E. The Kersting Deposition (October 1988)..................121
VIII. Trial of Test Cases (January 1989)......................123
A. Mr. Cravens.............................................124
B. Mr. Thompson............................................126
C. Mr. Kersting............................................129
D. Mr. Alexander...........................................130
E. Mr. DeCastro............................................133
F. Comfort Letters.........................................133
G. Mr. Izen's Introduction of Evidence of Collection
Litigation..............................................135
IX.
Posttrial Developments..................................137
A. First Thompson Refund...................................137
B. Mr. Izen's Motion To Reopen Record......................141
C. Dixon II Opinion........................................142
D. Disclosure of Thompson Settlement.......................143
E. Disclosure of Cravens Settlement........................152
F. Respondent's Motions To Vacate..........................155
- 6 G. Attempted Discovery by Counsel for Nontest Case
Petitioners.............................................156
H. Closing of Thompson Cases/Further Refunds...............156
I. Closing of Cravens Cases................................160
PROCEDURAL HISTORY OF EVIDENTIARY HEARING.....................162
I.
Developments Before Evidentiary Hearing.................162
A. Referral of Thompson and Cravens Settlements to Office
of Inspector General....................................162
B. Revival of 7-Percent Settlement Offer...................165
C. Disciplinary Actions....................................165
D. Indictment of Mr. Izen..................................166
E. Pretrial Conference (July 1995).........................167
F. Pretrial Conference (January 1996)......................168
G. Denial of Respondent's Motion To Disqualify Mr. Izen....168
H. Mr. DeCastro's Withdrawal...............................170
I. Discovery of Alexander Decisions and Referral to
Office of Inspector General.............................170
J. Mr. Izen's Motion To Compel Production of Documents
and Issuance of Protective Orders.......................171
K. Burden of Proof and Rule 145 Order......................173
II.
The Evidentiary Hearing.................................175
A. Testimony...............................................176
1. Mr. Cravens......................................... 176
2. Mr. Thompson.........................................178
3. Mr. Alexander........................................179
4. Mr. McWade...........................................180
5. Mr. Sims.............................................182
6. Mr. DeCastro.........................................183
7. Mr. Izen.............................................184
B. Mr. Sticht's Allegations of Potential Witness
Intimidation............................................186
C. Mr. Bradt's June 12, 1996, Letter to Mr. Kersting.......187
D. Denial of Mr. Izen's Motion To Refer Thompson and
Cravens Settlements and Alexander Agreement to
Department of Justice (Public Integrity Section)........189
III. Developments Following Initial Evidentiary Hearing......189
A. Denial of Respondent's Motion for Further Hearing
Regarding Potential Witness Intimidation................189
B. Supplemental Evidentiary Hearing (August 18, 1997)......192
C. Denial of Mr. Izen's Motion To Compel Production of
Documents...............................................194
D. Denial of Mr. Sticht's Motion To Reopen Record..........195
E. Denial of Mr. Izen's Motion To Take Judicial Notice.....196
F. Denial of Mr. Sticht's Motions for Release From
Piggyback Agreements....................................198
G. Reports Regarding the Court's Protective Orders.........199
- 7 ULTIMATE FINDINGS OF FACT.....................................200
OPINION.......................................................202
I.
Burden of Proof.........................................203
II.
Structural Defect.......................................211
A. Case Law................................................211
B. Arguments...............................................215
C. Summary of Government Misconduct........................218
D. Discussion..............................................225
III. Harmless Error Analysis.................................233
A. Review of Dixon II......................................236
1. Mr. Kersting's Lack of Credibility...................237
2. Sham Analysis........................................238
3. Lack of Genuine Debt/Waltz of Funds..................240
i.
Subscription Interest...........................241
ii. Primary Loans...................................242
iii. Leverage Loans..................................244
4. Collection Litigation................................244
5. CAT-FIT Plan.........................................245
6. Additions to Tax.....................................247
i.
Negligence......................................247
ii. Late Filing.....................................247
iii. Substantial Understatement......................247
iv. Increased Interest..............................248
B. Discussion..............................................249
1. Mr. Cravens.........................................249
i.
Sham Analysis...................................251
ii. Lack of Genuine Debt/Waltz of Funds.............254
2. Mr. Thompson.........................................255
i.
Sham Analysis...................................257
ii. Lack of Genuine Debt/Waltz of Funds.............258
iii. Additions to Tax................................262
3. Mr. Alexander........................................264
4. Summary..............................................266
IV.
V.
Fraud, Misrepresentation, and Misconduct................267
VI.
Fraud on the Court......................................271
A. Case Law Survey.........................................271
B. Discussion..............................................281
Mr. Izen's Allegations That Mr. DeCastro Was a "Mole"...283
VII. Enforceability of Piggyback Agreements..................284
A. Principles of Contract Law..............................285
B. Discussion..............................................290
1. Benefit of the Bargain...............................290
2. Mr. Seery's Purported Conflict of Interest...........294
- 8 3. Rejection of Mr. Izen's Argument for Entry of
Decision On the Basis of Thompson Decisions..........296
VIII. Mary Carter Agreements..................................296
IX.
Mr. Sticht's Motion To Sever Case and for Entry of
Decision or Alternatively To Sever Case and Set for
Trial ..................................................300
X.
Protective Orders.......................................302
XI.
Sanctions...............................................305
Conclusion....................................................307
SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge:
Eight of these consolidated cases--with five
petitioners represented by Joe Alfred Izen, Jr. (Mr. Izen),--are
test cases before the Court on remand from the Court of Appeals
for the Ninth Circuit in DuFresne v. Commissioner, 26 F.3d 105
(9th Cir. 1994), vacating and remanding per curiam Dixon v.
Commissioner, T.C. Memo. 1991-614.
The other 10 consolidated cases--with petitioners in one
case represented by Mr. Izen and the other petitioners
represented by Robert Alan Jones (Mr. Jones) and Robert Patrick
Sticht (Mr. Sticht)--are nontest cases that have been added to
the consolidated group in order to effectuate the direction of
the Court of Appeals "to consider on the merits all motions of
intervention filed by parties affected by this case."
Id. at
107.
Unless otherwise indicated, section references are to the
Internal Revenue Code, as amended, and Rule references are to the
Tax Court Rules of Practice and Procedure.
- 9 Introduction
These consolidated cases are part of a group of more than
1,300 remaining cases--more than 500 cases have settled--arising
from respondent's disallowance of interest deductions claimed by
participants in various tax shelter programs promoted by Henry
F.K. Kersting (Mr. Kersting).
The Kersting group of cases
(hereinafter the Kersting project) was assigned to Judge
William A. Goffe (Judge Goffe) for disposition.
By agreement of
the parties and the Court, the merits of the Kersting programs
were to be litigated in a consolidated trial of 14 docketed cases
of eight petitioners that had been designated as "test cases".
The vast majority of the remaining Kersting project petitioners
signed stipulations to be bound (sometimes referred to herein as
piggyback agreements) in which they agreed with respondent that
their cases would be resolved in accordance with the Court's
opinion in the test cases.
Before the trial of the test cases, some test case
petitioners argued that a 1981 search of Mr. Kersting's office
had been illegal, that materials seized during the search should
be suppressed in the test case proceedings, and that the burden
of proof and burden of going forward with evidence should be
shifted to respondent.
In Dixon v. Commissioner, 90 T.C. 237
(1988) (Dixon I), the Court held, in an opinion by Judge Goffe,
that the petitioners had failed to establish standing to contest
the Kersting search and seizure.
- 10 Judge Goffe held the trial of the test cases in Honolulu,
Hawaii, during January 1989.
The majority of the test case
petitioners were represented at trial by Mr. Izen.
However, test
case petitioners John R. and Maydee L. Thompson (docket Nos.
19321-83, 31236-84, and 30965-85) were represented at trial by
Luis C. DeCastro (Mr. DeCastro), and test case petitioners John
R. and E. Maria Cravens (docket Nos. 16900-83 and 15135-84)
appeared pro sese.
Following the trial of the test cases, the Court issued its
memorandum opinion in Dixon v. Commissioner, T.C. Memo. 1991-614,
62 T.C.M. (CCH) 1440, 1991 T.C.M. (RIA) par. 91,614 (Dixon II),
sustaining virtually all of respondent's determinations in each
of the test cases, and entered decisions against the test case
petitioners in accordance with its opinion.
On March 13, 1992, the Court entered the following decisions
in the Thompson and Cravens cases:
John R. and Maydee L. Thompson
Year
Deficiency
Sec.
6651(a)
Additions to Tax
Sec.
Sec.
6653(a) 6653(a)(1)
1979
1980
1981
$18,161.00
24,838.00
36,294.52
----$4,934.32
$908
-----
----$1,958.28
Sec.
6653(a)(2)
----50 percent of
the interest
due on the
deficiency
John R. and E. Maria Cravens
Year
Deficiency
Additions to Tax
Sec. 6653(a)
1979
1980
$4,508.00
5,893.45
$225.40
294.67
- 11 On June 9, 1992, respondent filed motions for leave to file
motions to vacate the decisions entered against the Thompsons,
the Cravenses, and another test case petitioner, Ralph J. Rina
(Mr. Rina), docket No. 17640-83.
Respondent's motions to vacate
alleged that, before the trial of the test cases, respondent's
trial attorney, Kenneth W. McWade (Mr. McWade), and his
supervisor, Honolulu District Counsel William A. Sims (Mr. Sims),
had entered into contingent settlement agreements with the
Thompsons and the Cravenses that had not been disclosed to the
Court or to the other test case petitioners or their counsel.
Respondent asked the Court to conduct an evidentiary hearing to
determine whether the undisclosed agreements with the Thompsons
and the Cravenses had affected the trial of the test cases or the
opinion of the Court.
On June 22, 1992, Judge Goffe granted respondent's motions
to vacate filed in the Thompson and Cravens cases, vacated the
decisions entered in those cases, ordered the parties to file
agreed decisions with the Court, or otherwise move as
appropriate, and denied respondent's request for an evidentiary
hearing.
By order dated June 22, 1992, Judge Goffe also denied
respondent's motion to vacate the decision entered against
Mr. Rina, on the ground that the testimony, stipulated facts, and
exhibits relating to the Thompson and Cravens cases had no
material effect on the Court's Dixon II opinion as it related to
Mr. Rina.
- 12 On July 22, 1992, the test case petitioners represented by
Mr. Izen filed a motion for reconsideration of the Court's order
denying respondent's motion to vacate the decision in the Rina
case.
By order dated August 4, 1992, Judge Goffe denied
petitioners' motion for reconsideration.
In August 1992, the Court entered revised decisions in the
Thompson and Cravens cases consistent with Mr. McWade's prior
agreements with the taxpayers in those cases.
Specifically, the
Court entered the following decisions in the Thompson and Cravens
cases:
John R. and Maydee L. Thompson
Year
Deficiency
Additions to Tax
1979
1980
1981
--$15,000
15,000
-------
John R. and E. Maria Cravens
Year
Deficiency
Additions to Tax
1979
1980
$3,606.40
6,175.76
-----
The decisions entered in the Thompson and Cravens cases are now
final.2
2
Mr. Izen and Mr. Sticht filed separate motions with the
Court to intervene in the Thompson and Cravens cases. The Court
denied these motions to intervene. Although Mr. Izen and
Mr. Sticht filed separate appeals in the Thompson and Cravens
cases with various courts, including the Courts of Appeals for
the Second, Ninth, and Tenth Circuits, all appeals in the
Thompson and Cravens cases eventually were dismissed. In an
unpublished opinion filed June 15, 1994, the Court of Appeals
for the Ninth Circuit stated:
(continued...)
- 13 Because of Judge Goffe's termination, on September 30, 1992,
of his recall status as a Senior Judge of the Court, all cases in
the Kersting project group were reassigned to Judge Renato Beghe.
The other test case petitioners, including Mr. Rina,
appealed the decisions entered in their cases to the Court of
Appeals for the Ninth Circuit.
On appeal, those petitioners
argued that the trial of the test cases had been tainted by the
Thompson and Cravens settlement agreements.
The response of the
Court of Appeals was to vacate the decisions in the remaining
test cases and remand them to this Court with directions "to
conduct an evidentiary hearing to determine the full extent of
the admitted wrong done by the government trial lawyers."
DuFresne v. Commissioner, 26 F.3d at 107.
The Court of Appeals,
citing Arizona v. Fulminante, 499 U.S. 279, 309 (1991), directed
the Court to consider "whether the extent of misconduct rises to
the level of a structural defect voiding the judgment as
fundamentally unfair, or whether, despite the government's
misconduct, the judgment can be upheld as harmless error."
DuFresne v. Commissioner, supra at 107.
2
Further, the Court of
(...continued)
The Tax Court's August 25 and 26, 1992 decisions
entering settlement in the Cravens and Thompson cases,
respectively, are final. 26 U.S.C. § 7481(a)(1); Fed.
R. App. P. 13. The Tax Court lacks jurisdiction to
vacate those decisions. Billingsley v. CIR, 868 F.2d
1081, 1084 (9th Cir. 1989). Because there is no case
remaining in which the taxpayers can intervene, this
appeal is moot. [Adair v. Commissioner, No. 92-70812,
26 F.3d 129 (9th Cir. 1994).]
- 14 Appeals directed this Court to consider on the merits all motions
See id.3
of intervention filed by parties affected by Dixon II.
On February 2, 1995, respondent filed a Motion for an
Evidentiary Hearing.
On September 14, 1995, the Court granted
respondent's motion.
To effectuate the direction of the Court of
Appeals regarding intervention, the Court ordered that the cases
of 10 nontest case petitioners, the majority of whom had
previously signed piggyback agreements, be consolidated with the
remaining test cases for purposes of the evidentiary hearing.4
As a result, three groups of petitioners have participated in all
subsequent phases of the evidentiary hearing:
Test case and
nontest case petitioners represented by Mr. Izen; nontest case
petitioners represented by Mr. Jones; and nontest case
petitioners represented by Mr. Sticht.5
The positions taken by
3
The appellate panel in DuFresne v. Commissioner, 26 F.3d
105, 107 (9th Cir. 1994), vacating and remanding per curiam Dixon
v. Commissioner, T.C. Memo. 1991-614, 62 T.C.M. (CCH) 1440, 1991
T.C.M. (RIA) par. 91,614 (Dixon II), issued an order stating that
the panel would retain jurisdiction over any subsequent appeal.
4
On June 13, 1995, test case petitioner Mr. Rina conceded
his case in full, resulting in entry of a stipulated decision in
docket No. 17640-83 that was identical with the decision
originally entered in that case on the basis of the Court's
opinion in Dixon II.
5
The group of cases that were consolidated for purposes of
the evidentiary hearing initially included the case of William D.
and Karen S. Booth, docket No. 28950-88, in which Declan J.
O'Donnell (Mr. O'Donnell) had entered his appearance. However,
at the start of the evidentiary hearing, the Court granted
Mr. O'Donnell's motion to sever the Booth case from the cases
consolidated for the evidentiary hearing. Mr. O'Donnell argued
that, in light of the theory underlying a Motion for Summary
Judgment that he had filed on behalf of the Booths, they had no
(continued...)
- 15 the various groups of petitioners during these proceedings have
not been consistent in all respects and in some respects the
positions of counsel--primarily Messrs. Izen and Sticht--have
become adversarial.6
Following pretrial conferences on the record in Los Angeles
on July 17, 1995, and January 16, 1996, the evidentiary hearing
was held at special trial sessions of the Court conducted in Los
Angeles on May 13 to 30 and June 10 to 26, 1996, and August 18,
1997.
In the interest of chronology and as an aid to understanding
this opinion, the procedural history of the evidentiary hearing
comes after the Court's detailed findings of fact and before the
ultimate findings of fact.
FINDINGS OF FACT
I.
Kersting Tax Shelter Programs and Related Matters
A.
The Pike Case
Mr. Kersting began promoting tax shelter programs in Hawaii
in the early 1970's.
Mr. Kersting's early tax shelter programs
included an "Auto-Leasing Plan" and an "Acceptance Corporation
Plan."
Those plans generally required participants to purchase
5
(...continued)
need to participate in the evidentiary hearing. In Gridley v.
Commissioner, T.C. Memo. 1997-210, the Court rejected the
argument, raised in the Booths' Motion for Summary Judgment,
that Kersting petitioners who signed stipulations to be bound
to Dixon II were entitled to entry of decisions in their cases
consistent with the decision entered by the Court in the Thompson
case at docket No. 19321-83.
6
See infra pp. 168-169, 171-172, and 187-188.
- 16 stock in a subchapter S leasing corporation or an acceptance
corporation and/or enter into a subscription agreement to
purchase stock, all in connection with loans to the participants
by various entities created by Mr. Kersting.
The plans were
primarily designed to generate income tax deductions for interest
that the participants purportedly paid to the Kersting entities
on the loans.
The Commissioner determined that participants in
Mr. Kersting's auto-leasing and acceptance corporation plans were
not entitled to deduct:
(1) "Interest" that participants claimed
to have paid on either the Auto-Leasing stock purchase or
leverage loans; (2) the participants' pro rata shares of losses
or investment credits from the auto leasing companies; and
(3) "interest" that participants claimed to have paid either on
the acceptance corporation stock purchase or stock subscription
loans.
In Pike v. Commissioner, 78 T.C. 822 (1982), affd. without
published opinion 732 F.2d 164 (9th Cir. 1984), this Court
sustained the Commissioner's disallowances of all deductions for
interest, losses, and credits claimed by participants in
Mr. Kersting's early programs.
B.
Kersting Criminal Investigation
While the Pike litigation was underway, Mr. Kersting
continued to promote additional tax shelter programs, which came
to be known as the stock purchase plan, the stock subscription
plan, the leasing company plan, and the CAT-FIT plan.
The
- 17 Court's opinion in Dixon II describes the mechanics of these
programs in detail.7
On January 22, 1981, following an undercover criminal
investigation, the Internal Revenue Service searched
Mr. Kersting's offices in Hawaii pursuant to a search warrant
issued by the U.S. District Court for the District of Hawaii.
Seventy-seven boxes and two filing cabinets of records were
seized from Mr. Kersting's office, including lists identifying,
by name and address, approximately 1,800 participants in
Mr. Kersting's programs, and schedules of the interest
purportedly paid by each participant to one or more Kersting
companies during the taxable years 1977, 1978, and 1979.
On January 24, 1981, Mr. Kersting wrote a form letter to the
participants of his programs, one of his many "Dear Friend"
letters, stating that he had been entrapped by an undercover
Internal Revenue Service special agent into creating a backdated
"tax deduction" of $21,600.8
By letter dated February 15, 1981,
Mr. Kersting provided participants in his programs with "tax
reporting notices", presumably for the 1980 tax year, and
encouraged them to "take full advantage of the deductions
7
The Kersting programs involved a number of corporations
(hereinafter Kersting corporations). Mr. Kersting served as both
a director and president of most of these corporations and also
sometimes owned stock. For those corporations in which he served
as president during the years in issue, he had exclusive
management authority.
8
The record in these cases contains no fewer than 38 "Dear
Friend" letters.
- 18 reported to you."
Mr. Kersting further informed participants
that the Internal Revenue Service had "accomplished only a
temporary disruption of our operations" and that his office was
"back to almost normal workings".
All records seized in the
January 22, 1981, search were returned to Mr. Kersting by 1987.
In January 1983, Mr. Kersting filed suit in the U.S.
District Court for the District of Hawaii (docket No. CV-83-0018MP) against the United States, the Internal Revenue Service, and
certain Internal Revenue Service agents alleging, inter alia,
that the January 1981 search was illegal and that the defendants
had abused the grand jury process by shopping for a favorable
grand jury, by violating grand jury secrecy, and by using the
grand jury as a civil investigation tool.
Through a number of
unpublished orders, the District Court and the Court of Appeals
for the Ninth Circuit rejected Mr. Kersting's claims.
See
Kersting v. United States, 865 F. Supp. 669, 674-675 (D. Haw.
1994).
C.
Assessments of Kersting Promoter Penalties
Mr. Kersting's tax shelter activities did not lead to an
indictment.
However, in October 1989, the Commissioner assessed
promoter penalties of $1,545,201 and $2,330,000 against
Mr. Kersting, pursuant to sections 6700 and 6701, respectively,
for the years 1982 through 1988.9
9
The District Court for the
Sec. 6700 provides for imposition of a penalty of a
percentage of the gross income derived from promoting an abusive
tax shelter, and sec. 6701 provides for imposition of a penalty
(continued...)
- 19 District of Hawaii sustained the Commissioner's assessments.
See
Kersting v. United States, Civil Nos. 90-00304, 91-00747, 9200593 (D. Haw., Sept. 30, 1994).
Mr. Kersting's appeal of that
decision to the Court of Appeals for the Ninth Circuit, docket
No. 94-16942, was argued and submitted on May 8, 1996, but
subsequently withdrawn from submission (with an opportunity for
supplemental briefing) until after this Court issues its opinion
in these consolidated cases.
D.
Kersting Notice of Deficiency
The Commissioner sent Mr. Kersting a notice of deficiency
determining deficiencies in and additions to his Federal income
taxes for the taxable years 1982 through 1988.
The deficiencies
were based upon the Commissioner's determination that cash
payments of so-called leverage loan interest received by Kersting
corporations, which were characterized by the District Court in
the promoter penalty cases as "alter egos" of Mr. Kersting, and
which the Court's Dixon II opinion characterized as fees paid to
Mr. Kersting by program participants in exchange for tax
deductions, were includable in Mr. Kersting's gross income.
Mr. Kersting filed a timely petition for redetermination with
this Court (assigned docket No. 7448-96), and the case was tried
at a Honolulu special trial session that commenced January 27,
1999.
9
(...continued)
of $1,000 (per incident) upon a person who knowingly aids or
assists another in understating his tax liability.
- 20 II.
Notices of Deficiency Issued to Kersting Program
Participants
In 1982, respondent began to issue notices of deficiency to
Kersting program participants, disallowing interest deductions
claimed with respect to the stock purchase plan, the stock
subscription plan, the leasing company plan, and the CAT-FIT plan
for a number of taxable years.
A.
Form of Notices of Deficiency
The notices of deficiency issued by respondent to many
Kersting program participants used a common format, stating in
pertinent part as follows:
EXPLANATION OF ADJUSTMENTS
1. It is determined that the following amounts claimed
on your
income tax return as interest deductions
are not allowable:
Amount
$---------
Purported Payee[10]
Any entity owned, associated
with, or controlled, either
directly or indirectly, by
Henry Kersting
This disallowance is based on the determination that
the transactions giving rise to the claimed interest
deduction are shams. This disallowance is further
based upon your failure to establish that the above
amounts were paid or properly accrued, or that the
transactions purportedly generating the claimed amounts
resulted either in any bona fide indebtedness or in any
enforceable and bona fide obligation to pay
compensation for use or forbearance of money on
indebtedness within the meaning of I.R.C. Section 163.
Furthermore, if it is established that any portion
of the above disallowed "interest" is a properly
10
In some instances, respondent's notices of deficiency
listed specific Kersting corporations under "Purported Payee".
- 21 allowable deduction, it is further determined that such
interest constitutes interest in investment
indebtedness and deduction of such amounts is limited
under the provisions of I.R.C. 163(d).
Further, and in support of a portion of the
determined deficiency, if you establish that you are
entitled to the above-mentioned interest deduction, it
is determined that you improperly failed to report the
income resulting from the same transaction.
2. It is determined that part of the underpayment of
tax for the taxable year ____ is due to your negligent
of [sic] intentional disregard of the rules and
regulations. Consequently, the 5 percent addition to
the tax is charged for ____ as provided by Section
6653(a) of the Internal Revenue Code.
B.
Thompson Notices of Deficiency
John R. Thompson (Mr. Thompson) was a pilot with Continental
Airlines from 1946 until his retirement in October 1982.
Mr. Thompson became aware of Mr. Kersting's programs through a
conversation with another pilot, Michael Provan (Mr. Provan), who
had solicited other pilots to participate in Mr. Kersting's
programs.11
The Thompsons began participating in Mr. Kersting's
programs in 1977.12
In addition to their participation in
11
Mr. Provan, who was at one time the president of one of
the Kersting companies, eventually became an adversary of
Mr. Kersting. See infra p. 66.
12
Although the Thompsons participated in one of
Mr. Kersting's programs during 1977, the Thompsons did not
claim any Kersting-related interest deductions on their 1977
return because their accountant-return preparer refused to
include them on the return.
The record suggests that the Thompsons' 1978 tax return
was prepared by Phil Scheff (an accountant recommended by
Mr. Kersting) and that the Thompsons claimed Kersting program
interest deductions on their return for that year. The Thompsons
experienced audit problems with their 1978 tax return that were
(continued...)
- 22 certain programs that were the subject of this Court's opinion in
Dixon II, the Thompsons, along with some 40 other investors,
including Mr. Provan, participated in a transaction arranged by
Mr. Kersting in early 1978 to acquire First Savings and Loan
Association of Hawaii (First Savings).
The Thompsons filed joint Federal income tax returns for
1979, 1980, and 1981 in which they claimed interest deductions
attributable to their participation in certain Kersting programs.
On May 5, 1983, June 13, 1984, and May 31, 1985, respondent
mailed notices of deficiency to the Thompsons determining
deficiencies in and additions to their Federal income taxes for
the taxable years 1979, 1980, and 1981, as follows:
Deficiency
Sec.
6651(a)
Additions to Tax
Sec.
Sec.
6653(a) 6653(a)(1)
1979 $18,161.00
1980 24,838.00
1981 36,294.52
----$4,934.32
$908
-----
Year
----$1,958.28
Sec.
6653(a)(2)
----50 percent of
the interest due
on the deficiency
Respondent further determined that the Thompsons were liable for
increased interest for 1981 pursuant to section 6621(d).13
The
12
(...continued)
due, in part, to their failure to attach to the return a Form W-2
showing the amount of tax that Continental Airlines had withheld
from Mr. Thompson's wages. In early to mid-1986, the Thompsons'
counsel, Samuel M. Huestis, negotiated a settlement of their tax
liability for 1978. The record does not disclose the terms of
the settlement.
13
Sec. 6621(d) was redesignated sec. 6621(c) by sec.
1511(c)(1)(A)-(C) of the Tax Reform Act of 1986 (TRA), Pub. L.
99-514, 100 Stat. 2744. We will hereinafter refer to the
(continued...)
- 23 Thompsons filed timely joint petitions for redetermination of the
above-described deficiencies.
C.
Cravens Notices of Deficiency
John R. Cravens was a pilot with American Airlines during
1979 and 1980.
Mr. Cravens became aware of Mr. Kersting's
programs through conversations with other pilots.
The Cravenses filed joint Federal income tax returns for
1979 and 1980 in which they claimed interest deductions
attributable to their participation in certain Kersting programs.
On April 15, 1983, and March 20, 1984, respondent mailed notices
of deficiency to the Cravenses determining deficiencies in and
additions to their Federal income taxes for the taxable years
1979 and 1980, as follows:
Year
Deficiency
Additions to Tax
Sec. 6653(a)
1979
1980
$4,508.00
19,251.70
$225.40
962.59
The notice of deficiency issued to the Cravenses for 1979, while
disallowing interest deductions of $9,810, included a credit for
personal exemptions of $4,000, resulting in a net adjustment of
$5,810.
The notice of deficiency issued to the Cravenses for
1980 included disallowed interest deductions of $19,620 and, as
an alternative to the disallowance of such interest, the
inclusion of $18,000 in unreported dividend income from a
Kersting controlled entity known as Candace Acceptance Corp.
13
(...continued)
provision as sec. 6621(c).
- 24 (Candace).
The notice of deficiency issued to the Cravenses for
1980 also included the disallowance of two personal exemptions
claimed for the Cravenses' children.
The Cravenses filed timely
joint petitions for redetermination contesting the abovedescribed notices of deficiency.
The Cravenses' reporting position was unique among the test
case petitioners insofar as the Cravenses had adjusted (reduced)
their tax basis in their Candace stock by the amount of a "nontaxable distribution" from Candace in 1980.
Having reduced the
basis of their Candace stock, the Cravenses reported a capital
gain of $7,200 on their 1980 tax return after surrendering the
stock to Mr. Kersting in exchange for cancellation and return of
the note evidencing their primary loan.14
D.
Alexander Notices of Deficiency
Denis Alexander (Mr. Alexander) is a broker and investor
who first met Mr. Kersting in Los Angeles in the early 1960's.
Mr. Alexander lent money to Mr. Kersting's subchapter S leasing
corporations in the 1970's, participated in the acquisition of
First Savings, and participated in some of the Kersting programs
at issue in Dixon II.
14
Although the Cravenses' reporting position was unique
insofar as they had reported a capital gain in a taxable year in
dispute before the Court, we note that test case petitioners
Robert L. and Carolyn S. DuFresne had also reported a capital
gain (albeit in a year subsequent to the years in dispute)
upon the surrender of stock in Charter Financial Corp. to
Mr. Kersting. Like the Cravenses', the DuFresnes' capital gain
was attributable to their reduction of the tax basis of their
stock as opposed to an increase in its value.
- 25 1.
1974 and 1975
Mr. Alexander and his wife, Freida, filed joint Federal
income tax returns for the taxable years 1974, 1975, 1976, and
1977.
Following an examination of their returns for 1974 and
1975, the Alexanders conceded certain adjustments proposed by
respondent, resulting in agreed assessments of $2,133 and $811
for 1974 and 1975, respectively.15
However, because the
Alexanders declined to agree to other proposed adjustments,
respondent, on November 29, 1979, issued a notice of deficiency
determining deficiencies of $4,891.83 and $40,760.38,
respectively, in their Federal income taxes for 1974 and 1975.
Respondent's deficiency determinations against the
Alexanders for 1974 and 1975 were based, in part, on disallowance
of interest deductions of $2,917 and $46,500, respectively,
attributable to their participation in Kersting programs for
those taxable years.
Additional adjustments included
disallowance of an $18,500 capital loss claimed by the Alexanders
for 1974 on a sale of stock in Mendocino Financial Corp. and
respondent's determination that they had failed to report a
$59,080 capital gain for 1975 from a sale of real estate to the
Cadillac Drive Apartments partnership.
15
The Alexanders were represented during the audit
by their accountant, Gilbert Matsumoto (Mr. Matsumoto). Mr.
Matsumoto had served as the accountant for some of Mr. Kersting's
subchapter S leasing corporations, and Mr. Kersting had
recommended that program participants use Mr. Matsumoto, among
others, to prepare their tax returns.
- 26 On February 28, 1980, the Alexanders filed a timely petition
with the Court, assigned docket No. 2758-80, contesting the
notice of deficiency for 1974 and 1975.
2.
1976 and 1977
Respondent also examined the Alexanders' joint income tax
returns for 1976 and 1977.
On April 17, 1986, respondent issued
the Alexanders a notice of deficiency determining deficiencies in
and additions to their 1976 and 1977 Federal income taxes, as
follows:
Year
Deficiency
Additions to Tax
Sec. 6653(a)
1976
1977
$3,596
876
$180
44
Respondent also determined that the Alexanders were liable for
increased interest for 1976 pursuant to section 6621(c).
The deficiencies that respondent determined against the
Alexanders for 1976 and 1977 resulted, in part, from respondent's
disallowance of interest deductions of $8,665 and $12,993,
respectively, attributable to their participation in Kersting
programs for those years.
Respondent also disallowed a $5,149
partnership loss claimed by the Alexanders for 1976 on their
investment in the Avista Epsilon and Sarbonne partnership.
On July 21, 1986, the Alexanders filed a petition through
Mr. Kersting's office, assigned docket No. 30413-86, contesting
the notice of deficiency for 1976 and 1977.
- 27 E.
Validity of Notices of Deficiency
In Dixon II, the Court considered and rejected arguments by
the test case petitioners represented by Mr. Izen that the
notices of deficiency issued to them were invalid under Scar v.
Commissioner, 814 F.2d 1363 (9th Cir. 1987), revg. 81 T.C. 855
(1983).
After the evidentiary hearing in these proceedings, the
Court rejected the Scar argument advanced by Mr. Jones on behalf
of a Kersting participant who had settled his case before the
trial of the test cases in Dixon II.
See Richards v.
Commissioner, T.C. Memo. 1997-149, supplemented by T.C. Memo.
1997-299, affd. without published opinion 165 F.3d 917 (9th Cir.
1998).16
F.
Errors in Notices of Deficiency
Although this Court rejected the argument that notices of
deficiency issued to Kersting program participants were invalid,
it is evident that some notices of deficiency issued to Kersting
program participants did contain errors.
For instance, in
Richards v. Commissioner, supra, it appears that respondent
overstated the deficiency using an excessive tax rate of 70
percent.
In addition, the petition filed in the Richards case
included an allegation that respondent disallowed interest
16
Although Luis C. DeCastro had negotiated the settlement
on behalf of Mr. and Mrs. Richards, he did not participate in the
filing or prosecution of Mr. Jones' motion to vacate the decision
entered in their case.
- 28 deductions in excess of Kersting interest deductions that the
Richardses actually claimed.17
Similarly, as observed in the Court's Dixon II opinion,
respondent's alternative determinations in the notice of
deficiency issued to the Cravenses overstated their deficiency
for 1980.
The Court ordered that the Cravenses' deficiency for
1980 be reduced to account for:
(1) The elimination of
respondent's alternative determination that the Cravenses failed
to report $18,000 in dividends paid by Candace; and (2)
respondent's failure to eliminate the capital gain of $7,200
reported by the Cravenses for 1980 on the disposition of their
Candace stock.
III. Commencement of Kersting Project
A.
Tax Shelter Projects and Test Case Procedures
1.
Overview
The large volume of cases generated by the Commissioner's
disallowances of deductions claimed by taxpayers participating in
large tax shelter programs during the late 1970's and early
1980's created the largest inventory of cases ever docketed in
the Tax Court.
Among the responses of the Internal Revenue
Service and the Tax Court were the development of procedures that
17
Test case petitioners Terry D. and Gloria K. Owens
alleged in their petition that respondent disallowed legitimate
interest deductions in their notice of deficiency. However, it
appears that the allegation was not pursued by or on behalf of
the Owenses, inasmuch as the decision entered by the Court in
their case, following the issuance of the Court's opinion in
Dixon II, was consistent with the deficiency determined by
respondent.
- 29 were intended to streamline the litigation process, economize on
the use of administrative and judicial resources, and reduce the
costs incurred by taxpayers in resolving disputes over tax
shelter adjustments.
The Internal Revenue Service, Office of
Chief Counsel, created the Tax Shelter Branch in the National
Office to oversee tax shelter litigation across the country and
to organize individual tax shelter projects.
Concurrently, the
Tax Court began working with the Internal Revenue Service and
private parties in tax shelter cases to create what became known
as the test case procedure; i.e., the selection of representative
or test cases from a particular tax shelter project for a single
trial on the merits.
See, e.g., Drobny v. Commissioner, T.C.
Memo. 1995-209 (citing H. Conf. Rept. 98-861, at 985-986 (1984),
1984-3 C.B. (Vol. 2) 1, 239-240), affd. 113 F.3d 670 (7th Cir.
1997).
The test case procedure is intended to streamline the
litigation process.
To this end, taxpayers who are not selected
as test cases are encouraged to execute a piggyback agreement;
i.e., a stipulation to be bound by the outcome of the test cases.
As a practical matter, the effectiveness of the test case
procedure depends in large part upon the agreement of the
taxpayers not selected as test cases to be bound by the outcome
of the test cases.
Normally, taxpayers in a tax shelter project
who decline or otherwise fail to sign a piggyback agreement will
either have their cases set for trial with the test cases or,
after the trial of the test cases, will be ordered to show cause
- 30 why their case should not be decided the same way as the test
cases.
See, e.g., Krause v. Commissioner, 99 T.C. 132 (1992),
affd. sub nom. Hildebrand v. Commissioner, 28 F.3d 1024 (10th
Cir. 1994); Acierno v. Commissioner, T.C. Memo. 1997-441;
Karlsson v. Commissioner, T.C. Memo. 1997-432.
Using the order
to show cause procedure to dispose of nontest cases in a tax
shelter project is more cumbersome and consumes more time and
judicial, administrative, and private party resources than using
piggyback agreements.
As discussed in greater detail below, the
Court used the test case procedure in the Kersting project; the
vast majority of the Kersting project participants signed
piggyback agreements.
2.
See infra pp. 34-41.
National Office Tax Shelter Branch Functions
The Tax Shelter Branch, established by the Office of Chief
Counsel in the National Office, was given the responsibilities of
coordinating the examination, appeals, and litigation functions
and of overseeing tax shelter projects from the National Office
perspective.
The Tax Shelter Branch provided advice and prepared
material for use by the field in tax shelter cases, reviewed
legal briefs, monitored the status of tax shelter case inventory,
and prepared reports for Internal Revenue Service executives.
The Tax Shelter Branch monitored tax shelter projects by
reviewing and extracting information from quarterly tax shelter
reports that were required to be submitted by the project
attorney; i.e., the District Counsel trial attorney with primary
responsibility for the project.
Each project attorney was
- 31 required to submit a quarterly tax shelter report providing an
update on the status of the project, including a summary of the
current project settlement offer and any recent court action
affecting the project.
One of the goals of the tax shelter program was consistent
treatment of similarly situated taxpayers.
The Tax Shelter
Branch monitored settlement offers in similar tax shelter
projects for disparities and tried to determine whether the
project settlement offers should be similar.
However, actual
supervisory responsibility in a tax shelter project was left
primarily in the Regional Counsel and District Counsel offices
to which the project was assigned.
B.
Petitions for Redetermination
In or around June 1982, Mr. Kersting facilitated the filing
of petitions with the Tax Court by Kersting program participants.
In letters issued in June and July 1982, Mr. Kersting informed
Kersting program participants that a joint petition was being
prepared on behalf of a large group of taxpayers.
On July 12,
1982, Lu N. Nevels, Jr., filed a consolidated Tax Court petition,
assigned docket No. 17445-82, on behalf of 60 Kersting program
participants.18
18
Lu N. Nevels, Jr., had represented the test case
taxpayers in Pike v. Commissioner, 78 T.C. 822 (1982), affd.
without published opinion 732 F.2d 164 (9th Cir. 1984). For an
example of the problems created by using one petition on behalf
of so many different petitioners, see Aaronson v. Commissioner,
T.C. Memo. 1985-131, involving the Hongsermeier petitioners in
what is now docket No. 29643-86. See infra p. 38.
- 32 C.
Brian J. Seery
In early 1982, Brian J. Seery (Mr. Seery) began assisting
Kersting program participants with issues arising from the audit
of their income tax returns.
On April 14, 1982, Mr. Kersting
issued a letter to Kersting program participants informing them
that they soon would receive a letter from the Commissioner
proposing to disallow their Kersting program interest deductions.
Mr. Kersting advised program participants that they should not
remit any amount to the Internal Revenue Service until their
liability was determined in court.
On February 15, 1983, Mr.
Kersting issued a letter to Kersting program participants stating
in pertinent part:
"I trust that you have placed the tax
retrievals which we have accomplished for you over the years into
profitable investments and that you are receiving a reasonable
rate of return.
You will not lose any ground if your funds earn
at least a return equal to the interest charges imposed by the
IRS from time to time."
On March 1, 1985, Mr. Kersting issued a letter to Kersting
program participants stating that he had retained Mr. Seery to
represent them in the Tax Court at no charge to the individual
petitioners.19
The letter requested that each Kersting program
participant provide written authorization for Mr. Seery's
19
Initially, Mr. Kersting or the entities that he
controlled paid the legal fees associated with the Tax Court
litigation. Later, however, some Kersting program participants
began paying $100 per month to a legal defense fund managed by
Mr. Kersting.
- 33 representation.
In a letter to program participants dated August
11, 1986, Mr. Kersting recommended that program participants not
attempt to resolve their cases on their own and instead rely on
counsel that he had hired.
Mr. Seery subsequently entered his appearance in the Tax
Court on behalf of several hundred Kersting petitioners,
including the Thompsons and the Cravenses.
Mr. Seery's
compensation for legal services rendered to Kersting program
participants was always paid by one of the corporations
controlled by Mr. Kersting.
D.
Respondent's Counsel
1.
Kenneth W. McWade
In 1970, Mr. McWade began his career as a trial attorney
with the Office of Chief Counsel.
Mr. McWade's duties with the
Office of Chief Counsel included litigating tax cases.
In January 1982, Mr. McWade transferred from respondent's
District Counsel office in Seattle, Washington, to respondent's
District Counsel office in Honolulu, Hawaii.
Mr. McWade
initially assisted with the Pike group of cases.
On or about
July 1, 1984, the Kersting project was officially established in
the Honolulu Appeals Office, and Mr. McWade was appointed to
serve as the project attorney.
Wally Kobayashi was appointed to
serve as the key Appeals officer for the Kersting project.
By late 1986, Mr. McWade had litigated 40 to 50 Tax Court
cases.
However, Mr. McWade had never litigated any cases that
were part of a tax shelter project.
- 34 2.
William A. Sims
In 1972, Mr. Sims began his career with the Office of Chief
Counsel, General Litigation Division, National Office.
Except
for a 6-month assignment doing Tax Court work, Mr. Sims handled
general litigation matters concerning collection, bankruptcy, and
tax liens.
Mr. Sims eventually became Assistant Director of the
General Litigation Division in the National Office.
In February 1986, Mr. Sims was appointed District Counsel
for Honolulu, Hawaii.
Before his appointment as District
Counsel, Mr. Sims had never worked on a tax shelter project in
any capacity.
E.
Adoption of Test Case Procedures in Kersting Project
1.
The Honolulu Session (June 1985)
The Court set for trial the cases of approximately 375
Kersting program participants at a Tax Court session scheduled to
commence on June 10, 1985, in Honolulu, Hawaii (the June 1985
session).
Before the June 1985 session, Mr. McWade and Mr. Seery
agreed to use the test case procedure in the Kersting project.
During the June 1985 session, Mr. McWade and Mr. Seery discussed
the use of the test case procedure with Judge Goffe during a
chambers conference.
During the conference, Mr. Seery informed
Judge Goffe that, although he was representing petitioners who
were Kersting program participants, he was being paid by Mr.
Kersting.
Judge Goffe indicated that he saw no conflict of
interest as long as Mr. Seery had not participated in the
- 35 planning or promotion of the Kersting programs.
See Rule
24(f).20
Consistent with counsels' agreement to use the test case
procedure in the Kersting project, Judge Goffe granted the
parties' joint motions to continue the cases called at the June
1985 session.
At the same time, the parties began filing
piggyback agreements (discussed in greater detail below), which
they did in the vast majority of the Kersting project cases.
Mr. Seery reported the results of the June 1985 proceedings
to Mr. Kersting and kept him abreast of developments.
Mr. Seery
relied upon Mr. Kersting to distribute correspondence from
Mr. Seery to petitioners in the Kersting project.
2.
Test Case Procedure
Mr. McWade and Mr. Seery agreed to select test cases that
would be representative of all the Kersting programs for all
years in dispute, including the taxable years 1975 through 1983.
At the time that Mr. Seery selected his test cases, he assumed
that the test case petitioners would bear the burden of proof at
trial.
In selecting test cases, Mr. Seery was not concerned with
whether a case involved other tax issues.
Mr. Seery was simply
looking for cases "where someone did everything right."
20
Rule 24(f), which became effective on July 1, 1990, see
93 T.C. 857, addresses conflicts of interest in Tax Court
litigation. Rule 24(f) was redesignated Rule 24(g) effective
Aug. 1, 1998. See 109 T.C. 542.
- 36 Mr. Seery selected two or three test cases, including the
Cravenses and the Hongsermeiers.
In an effort to find the best cases for trial from
petitioners' point of view, Mr. Seery selected test cases by
reference to the manner in which the taxpayers had reported the
transactions.
Mr. Seery selected test cases that he thought he
could win, but, as he testified at the evidentiary hearing, he
had difficulty identifying such cases in addition to the
Cravenses and the Hongsermeiers.21
Mr. Kersting and Mr. Cravens discussed having Mr. Cravens'
case serve as a test case.
Mr. Kersting told Mr. Cravens that
Mr. Seery wanted to use him as a test case because, unlike other
Kersting program participants, the Cravenses had reported a
capital gain when they surrendered their stock in the Kersting
holding company in conjunction with the annual termination of the
Kersting program.
The Cravenses' reporting position was
consistent with Mr. Kersting's advice to program participants
that distributions by Kersting holding companies used by program
participants to pay the principal amount of leverage loans were
tax-free returns of capital rather than taxable dividends.
Mr. Seery viewed the Cravens cases as "unique" in this respect.
Mr. Cravens believed that he had a choice whether his case
would serve as a test case.
21
When Mr. Cravens agreed to have his
Mr. Seery's testimony: "I was having trouble selecting
cases beyond those two that I thought would be good vehicles for
that."
- 37 case serve as a test case, he did so without condition.
He
believed that he would win his case because he had correctly
reported his tax liabilities, as reduced by reason of his
participation in the Kersting programs.
Mr. Seery selected the Hongsermeier case because it was his
impression that the Hongsermeiers had used their own funds to pay
the principal of a Kersting leverage loan, rather than using a
"nontaxable distribution" from a Kersting holding company.22
Mr. Seery also selected the Hongsermeiers because they had
participated in the CAT-FIT program, which Mr. Seery viewed as
the strongest Kersting program from the standpoint of sustaining
the interest deductions claimed.
Mr. McWade analyzed between 400 and 500 project cases; he
selected test cases that he thought would be representative of
all Kersting programs for all years in dispute.
Mr. McWade
selected "clean" cases; i.e., cases that did not include issues
other than Kersting interest deductions.
Mr. McWade tried to
avoid cases that were unique or atypical of the Kersting
programs.
Although Mr. McWade selected at least five of the test
cases, he could not recall the specific cases that he selected.
In June 1986, Mr. McWade and Mr. Seery agreed on the dockets
that were to serve as the test cases.
22
By letter dated June 10,
Mr. Seery's impression was not quite right. The Court
found in Dixon II that the Hongsermeiers were unique insofar as
they paid $250 per month out-of-pocket (rather than use the
proceeds from a leverage loan) to satisfy the interest due on
a CAT-FIT primary loan. See Dixon II, 62 T.C.M. (CCH) at 1480,
1991 T.C.M. (RIA), at 91-3023.
- 38 1986, Mr. McWade notified Judge Goffe that he and Mr. Seery had
selected the following 14 dockets to serve as test cases with
respect to the Kersting project:
Case Name
Dixon v. Commissioner
Cravens v. Commissioner
Rina v. Commissioner
Thompson v. Commissioner
Young v. Commissioner
Cravens v. Commissioner
DuFresne v. Commissioner
Thompson v. Commissioner
Owens v. Commissioner
Young v. Commissioner
Young v. Commissioner
Thompson v. Commissioner
DuFresne v. Commissioner
Hongsermeier v. Commissioner
Docket No.
9382-83
16900-83
17640-83
19321-83
4201-84
15135-84
15907-84
31236-84
40159-84
22783-85
30010-85
30965-85
30979-85
1
29643-86
1
By order dated Aug. 13, 1986, the Court severed the
Hongsermeiers from docket No. 17445-82 (the Aaronson consolidated
petition filed by Mr. Nevels) and assigned them new docket No.
29643-86. See supra note 18 and accompanying text.
With the exception of the Cravens case assigned docket No.
16900-83, and the Hongsermeier case assigned docket No. 17445-82,
each of the test case petitioners had filed pro se petitions.
By
August 1986, Mr. Seery had entered his appearance in each of the
test cases with the exception of the Young cases assigned docket
Nos. 4201-84, 22783-85, and 30010-85, the DuFresne case assigned
docket No. 30979-85, and the Thompson case assigned docket No.
30965-85.
3.
Test Case Array
The test case petitioners had participated in Kersting
programs during the taxable years 1975 through 1983 as follows:
- 39 Taxable Year 1975
Program
Petitioner(s)
CAT-FIT
MAURIER LEASING1
NORWICK 20/20
Owens
Owens
Owens
Taxable Year 1976
Program
Petitioner(s)
UNIVERSAL LEASING
FORBES 30/30
Owens
Owens
Taxable Year 1977
Program
Petitioner(s)
CAT-FIT
ESCON LEASING
FARGO 30/30
NORWICK 20/20
Dixon
Dixon
Dixon
Owens
Taxable Year 1978
Program
Petitioner(s)
CAT-FIT
CAT-FIT
UNIVERSAL LEASING
ESCON LEASING
ESCON LEASING
MAHALO 30/30
MAHALO 60/60
Hongsermeier
Dixon
Hongsermeier
Dixon
Hongsermeier
Owens
Dixon
Taxable Year 1979
Program
Petitioner(s)
CAT-FIT
CAT-FIT
UNIVERSAL LEASING
ANSETH LEASING
ANSETH LEASING
ESCON LEASING
ESCON LEASING
ESCON LEASING
CANDACE 60/60
CANDACE 60/60
CANDACE 60/60
Hongsermeier
Dixon
Hongsermeier
Rina
Young
Hongsermeier
Dixon
Thompson
Dixon
Cravens
Rina
- 40 CANDACE 60/60
CANDACE 60/60
CHARTER 80,000
CHARTER 120,000
INVESTORS 80,000
INVESTORS 120,000
Thompson
Young
Rina
Young
Rina
Young
Taxable Year 1980
Program
Petitioner(s)
CAT-FIT
CAT-FIT
CAT-FIT
ANSETH LEASING
ANSETH LEASING
ANSETH LEASING
ESCON LEASING
ESCON LEASING
ESCON LEASING
CANDACE 60/60
CANDACE 60/60
DELTA 40/40
DELTA 60/60
DELTA 60/60
DELTA 60/60
DELTA 60/60
DELTA 60/60
DELTA 60/60
CHARTER 40,000
CHARTER 80,000
CHARTER 120,000
CHARTER 120,000
CHARTER 120,000
CHARTER 120,000
INVESTORS 80,000
INVESTORS 80,000
INVESTORS 80,000
INVESTORS 120,000
INVESTORS 120,000
Dixon
DuFresne
Hongsermeier
Hongsermeier
Rina
Young
Dixon
Hongsermeier
Thompson
Cravens
Rina
Hongsermeier
Cravens
Dixon
DuFresne
Rina
Thompson
Young
Rina
Rina
Dixon
DuFresne
Thompson
Young
DuFresne
Rina
Thompson
Dixon
Young
Taxable Year 1981
Program
Petitioner(s)
ANSETH LEASING
ESCON LEASING
DELTA 60/60
CHARTER 120,000
CHARTER 120,000
CHARTER 120,000
Young
Dixon
Young
Dixon
DuFresne
Young
- 41 INVESTORS 80,000
INVESTORS 120,000
INVESTORS 120,000
DuFresne
Dixon
Young
Taxable Year 1982
Program
Petitioner(s)
ANSETH LEASING
CHARTER 120,000
CHARTER 120,000
INVESTORS 80,000
INVESTORS 120,000
Young
DuFresne
Young
DuFresne
Young
Taxable Year 1983
Program
Petitioner(s)
ANSETH LEASING
CHARTER 120,000
INVESTORS 80,000
Young
DuFresne
DuFresne
1
Maurier Leasing, a subch. S leasing program, was
considered by the Court in Pike v. Commissioner, 78 T.C. 822
(1982).
The notice of deficiency issued to the Thompsons for the
taxable year 1981 states in pertinent part:
"Based on
examination information from the 1978, 1979, and 1980 returns,
the investment interest is generated from the interest deduction
tax shelter.
The purported payees cannot be identified from the
1981 income tax return filed by the taxpayers."
Respondent has
not been able to identify specifically the Kersting programs that
the Thompsons participated in during 1981.
However, the record
suggests that, in addition to the Kersting programs that the
Thompsons participated in during 1979 and 1980, the Thompsons
participated in the Anseth Leasing Program during 1981.
If the Thompson and Cravens cases had been removed from the
test case array, there would have been no reduction in coverage
- 42 of the test cases.
In other words, each program in which the
Thompsons and Cravenses participated during the years in issue
was also a program before the Court in which one or more of the
other test case petitioners had participated.
IV.
The Maui Session (February 1987)
After Messrs. Seery and McWade had selected the test cases,
they initiated settlement negotiations and began to prepare the
test cases for trial.23
Their trial preparations included work
on a proposed stipulation of facts and an attempt to take
Mr. Kersting's deposition.
During this period (June 1986 or
thereabout), Mr. Seery and Mr. Kersting's attorney, L.T. Bradt
(Mr. Bradt), discussed using the 1981 search of Mr. Kersting's
office as a basis for filing a motion to shift the burden of
proof to respondent in the test cases.
A.
Trial Notices
By letter dated July 30, 1986, Judge Goffe informed
Messrs. Seery and McWade that the test cases would be set for
trial during a special session of the Court commencing on
February 9, 1987, in Wailuku, Maui, Hawaii (the Maui session).
Judge Goffe's letter also informed Messrs. Seery and McWade that
he intended to notify each Kersting petitioner who had not filed
a piggyback agreement that his or her case would be set for trial
during the Maui session.
23
Settlement negotiations between Mr. McWade and Mr. Seery
are discussed in greater detail infra pp. 78-80.
- 43 In August 1986, the Court issued orders setting the 14 test
cases for trial during the Maui session.
By letter dated
August 5, 1986, Judge Goffe informed all Kersting petitioners who
had not already executed piggyback agreements that their cases
would be set for trial at the Maui session unless they executed
piggyback agreements by September 29, 1986.
Judge Goffe's letter
states as follows:
August 5, 1986
Dkt #
Dear _______________:
Your case involves matters concerning promotions
by Henry Kersting. Cases with issues identical to the
issues in your case have been set for trial on
February 9, 1987, at the courtroom of the Circuit Court
for the Second Circuit in Wailuku, Maui, Hawaii.
In order to conserve the time and expense of the
taxpayers, the government and the Court, all of the
cases with identical issues will be tried at one time
unless the parties agree in advance, in writing, to be
bound by the outcome of the cases set for trial. In
most of the pending cases, the parties have so agreed
to be bound.
You should contact at your earliest convenience the
lawyer for the government in the Kersting cases if you
decide to agree to be bound. He is Mr. Kenneth McWade,
PJKK Federal Building, Room 3304, Box 50089, 300 Ala
Moana Boulevard, Honolulu, Hawaii 96850. His telephone
number is (808) 546-7333. If, however, you do not wish
to be bound, you should advise my office promptly, in
writing at the above address, in order that your case
may be set for trial on February 9, 1987. In either
event, you must advise Mr. McWade or me by
September 29, 1986.
If you fail to advise Mr. McWade by September 29,
1986, that you wish to be bound and have executed a
stipulation to be bound by that time and if you fail to
advise me by September 29, 1986, that you wish to have
your case set for trial, it will automatically be set
for trial on February 9, 1987. If your case is set for
- 44 trial and you do not appear for trial, your case will
likely be dismissed and you will be required to pay all
of the income tax which the government contends you
owe, plus interest thereon as provided by law.
William A. Goffe
Judge
In November 1986, the Court issued orders notifying Kersting
petitioners who had not filed piggyback agreements that their
cases were set for trial at the Maui session.
As additional
Kersting project cases were docketed and identified, the Court
issued orders setting them for trial at the Maui session, subject
to being stricken if the parties executed a piggyback agreement.
B.
Piggyback Agreements
As early as June 1985, Kersting program participants had
begun executing piggyback agreements (1985 piggyback
agreements),24 drafted by Messrs. McWade and Seery, that stated
as follows:
Stipulation of Settlement for Tax Shelter Adjustments
With respect to all adjustments in respondent's
notice of deficiency relating to the Kersting interest
deduction tax shelter(s), the parties stipulate to the
following terms of settlement:
1. The term Kersting programs refers to interest
expense deductions or other related deductions
associated with various programs promoted by Henry
Kersting.
2. The Kersting program deduction adjustments
shall be redetermined on the same basis that the same
program adjustments are resolved with respect to
taxpayers trying the same program adjustments at the
24
Before 1987, there was no uniform format for piggyback
agreements. In 1987 or early 1988, respondent's Tax Shelter
Branch issued a standard form of piggyback agreement.
- 45 June 10, 1985 session of the Court in Honolulu, Hawaii,
or such session as these cases may be adjourned or
continued to by the Court (hereinafter "TRIED CASE").
3. All issues involving the Kersting programs
shall be resolved as if the petitioner(s) in this case
is the same as the taxpayers in the TRIED CASE;
4. A decision shall be submitted in this case
when the decision in the TRIED CASE is entered;
5. Following entry of the decision in this case,
petitioner(s) consents to the assessment and collection
of the deficiencies, attributable to the adjustments
formulated by reference to the Tax Court's opinion,
notwithstanding the restrictions contained in I.R.C.
§ 6213(a);
6. The petitioner(s) in this case will testify or
provide information in any case involving the same tax
shelter adjustments, if subpoenaed; and
7. The petitioner(s) in this case consents to the
disclosure of all tax returns and tax return
information for the purpose of respondent's discovering
or submitting evidence in any case involving the same
Kersting shelter adjustments.
The parties agree to this stipulation of
settlement.
Piggyback agreements executed by Kersting program
participants after 1985 differed from those executed in 1985.
particular, post-1985 piggyback agreements stated as follows:
Stipulation of Settlement for Tax Shelter Adjustments
With respect to all adjustments in respondent's
notice of deficiency relating to the Kersting interest
deduction tax shelter(s), the parties stipulate to the
following terms of settlement:
1. The Kersting interest deduction tax shelter
adjustments shall be redetermined on the same basis
that the same tax shelter adjustments are resolved with
respect to taxpayers trying the same shelter
adjustments at the February 9, 1987 session of the
Court in Wailuku, Maui, Hawaii, or such session as
In
- 46 these cases may be adjourned or continued to by the
Court (hereinafter "TRIED CASE").
2. All issues involving the Kersting interest
deduction tax shelter(s) shall be resolved as if the
petitioner(s) in this case is the same as the taxpayers
in the TRIED CASE;
3. A decision shall be submitted in this case
when the decision in the TRIED CASE becomes final under
I.R.C. § 7481;
4. Following entry of the decision in this case,
petitioner(s) consent to the assessment and collection
of the deficiencies, attributable to the adjustments
formulated by reference to the Tax Court's opinion,
notwithstanding the restrictions contained in I.R.C.
§ 6213(a);
5. The petitioner(s) in this case will testify or
provide information in any case involving the same tax
shelter adjustments, if subpoenaed; and
6. The petitioner(s) in this case consents to the
disclosure of all tax returns and tax return
information for the purpose of respondent's discovering
or submitting evidence in any case involving the same
shelter adjustments.
7. If the Court determines the I.R.C. § 6621(d)
penalties are applicable in the test case controlling
petitioner's(s') case, then the petitioner(s) concedes
that I.R.C. § 6621(d) is applicable to any underpayment
of tax determined in their case(s) attributable to the
Kersting interest deduction tax shelter(s), if such
underpayment exceeds $1,000.00 in any one taxable year.
8. With respect to adjustments in respondent's
notice of deficiency relating to additions to the tax
under I.R.C. § 6653(a), the parties agree to the
following:
(a) Respondent concedes that the
petitioner(s) are not liable for additions to tax under
I.R.C. § 6653(a) or § 6653(a)(1) or § 6653(a)(2) for
any year prior to the taxable year 1982.
The parties agree to this stipulation of
settlement.
- 47 -
In sum, whereas paragraph 4 of the 1985 piggyback agreements
states that a decision will be entered in the piggyback case
following entry of decision in the test cases, paragraph 3 of the
post-1985 piggyback agreements states that a decision will be
entered in the piggyback case once the decision in the test cases
becomes final.25
210.
See Gridley v. Commissioner, T.C. Memo. 1997-
Unlike 1985 piggyback agreements, post-1985 piggyback
agreements state (at paragraph 7) that petitioners agree to be
bound to the Court's holding in the test cases respecting the
applicability of increased interest under section 6621(c) on any
underpayment of tax of more than $1,000.
Further, while 1985
piggyback agreements make no reference to additions to tax, post1985 piggyback agreements state (at paragraph 8) that petitioners
are not liable for additions to tax for negligence for any year
before the taxable year 1982.26
25
Despite this distinction, respondent did not move for
entry of decision--upon entry of decisions in the Kersting test
cases in early 1992--in any of the cases in which Kersting
petitioners had executed the 1985 version of the piggyback
agreement. Respondent has taken the position that no decisions
should be entered in any of the piggyback cases until the
decisions in the test cases become final. Cf. Abatti v.
Commissioner, 859 F.2d 115 (9th Cir. 1988), affg. 86 T.C. 1319
(1986).
26
Although the record does not reveal why post-1985
piggyback agreements limit respondent's concession of additions
to tax for negligence to taxable years before 1982, a plausible
explanation for selecting 1982 as the line of demarcation would
be that the Tax Court had released its opinion in Pike v.
Commissioner, 78 T.C. 822 (1982), in May 1982, putting taxpayers
on notice for 1982 and later taxable years that Mr. Kersting's
programs did not generate legitimate interest deductions.
- 48 When Messrs. McWade and Seery drafted the piggyback
agreements, Mr. Seery did not consider the possibility that a
test case might be settled.27
Nontest case petitioners Ronald L. and Mattie E. Alverson
(docket No. 17646-83) executed their piggyback agreement in June
1985.
Nontest case petitioners Anthony E. and Carol A. Eggers
(docket No. 7323-84), John L. and Terry E. Huber (docket No.
20119-84), Stanley C. and Sharon A. Titcomb (docket No. 1799295), and Richard B. and Donna G. Rogers (docket No. 17993-95)
executed piggyback agreements in late November 1986.
Nontest
case petitioners Norman W. and Barbara L. Adair (docket No.
35608-86) executed their piggyback agreement in March 1987.
Nontest case petitioners Willis F. McComas, II and Marie D.
McComas (docket No. 19464-92), Wesley Armand and Sherry Lynn
Cacia Baughman (docket No. 621-94), Joe A. and JoAnne Rinaldi
(docket No. 7205-94), and Norman A. and Irene Cerasoli (docket
No. 9532-94) did not execute piggyback agreements for their cases
on these dockets.
C.
Mr. Seery's Withdrawals as Counsel
During late 1986 and early 1987, and shortly before the Maui
session, Mr. Seery began to withdraw as counsel in the Kersting
cases in the circumstances described below.
27
A piggyback agreement that binds the piggyback case to
the outcome of the test case, whether by litigation or
settlement, is not unprecedented. See, e.g., Fisher v.
Commissioner, T.C. Memo. 1994-434.
- 49 1.
The Thompsons
In 1985, the Thompsons had retained Samuel M. Huestis
(Mr. Huestis) to prepare an estate plan for them.
Eventually,
the scope of Mr. Huestis' representation was extended to include
settlement of the Thompsons' 1978 tax liabilities and their
dispute with Mr. Kersting, as described infra pp. 56-67.
One result of that dispute was Mr. Huestis' letter of
September 10, 1986, to Mr. Seery, notifying him that the
Thompsons were seeking substitute counsel and requesting the
Thompson files.
On September 15, 1986, Mr. Seery sent the
Thompson files to Mr. Huestis and informed him that the Thompsons
were test case petitioners.
Mr. Seery indicated that he was
withdrawing as the Thompsons' counsel in the Tax Court.
On October 28, 1986, Mr. Huestis wrote to Mr. Seery to
express dissatisfaction with the sufficiency of the Thompsons'
files and to warn Mr. Seery that his earlier representation of
the Thompsons, while he was also apparently representing
Mr. Kersting, could be viewed as a conflict of interest and lead
to an action for "professional negligence".
On October 31, 1986, Mr. Seery filed motions to withdraw as
counsel in the Thompsons' cases.28
The Court granted Mr. Seery's
motions in November 1986.
28
Mr. Seery had entered his appearance only in the
Thompson cases assigned docket Nos. 19321-83 and 31236-84, not
docket No. 30965-85.
- 50 In the interim, Mr. Huestis assisted the Thompsons in
locating and interviewing Mr. DeCastro to serve as their counsel
in the Tax Court.29
On November 15, 1986, Mr. Thompson and
Mr. DeCastro's associate, Phillip Hoskins, executed a retainer
agreement under which Mr. Thompson agreed to pay Mr. DeCastro
$5,000 for his effort to negotiate a settlement of the Thompson
tax cases.
The agreement provided that the retainer fee was
limited to settlement negotiations and did not include
preparation for or representation at trial.
In early January
1987, Mr. DeCastro filed an entry of appearance in the Thompson
cases.
2.
The Test Cases
On November 7, 1986, Mr. Seery filed a motion to change
the place of trial of the test cases from Maui to Honolulu.
Mr. Seery asserted that a trial in Maui would be inconvenient and
a hardship to Mr. Kersting, who lived and operated a business in
Honolulu.
Mr. Seery's motion included the statement that
4. Mr. Kersting is providing the financial
support for the litigation of this and the related
cases and the additional expense involved in
transporting witnesses and staff to Wailuku as well
as paying for accommodations for the staff while in
Wailuku is a great financial burden to him.
On November 14, 1986, the Court issued an order denying
Mr. Seery's motion to change the place of trial.
29
In so doing,
Mr. Huestis had initially referred the Thompsons to a
law firm, Loeb & Loeb, in Los Angeles, California. The Loeb firm
declined to represent the Thompsons because of the short time to
prepare for the Maui session and the incompleteness of the
Thompson files.
- 51 the Court noted that the motion "implies that * * * [Mr. Seery]
represents not only petitioners but also Henry Kersting, the
promoter of the tax shelters which are the subject of this
litigation."
The Court went on to observe that, if Mr. Seery
were representing both Mr. Kersting and petitioners, the dual
representation would constitute a conflict of interest.
The
Court attached to the order copies of several authorities
concerning conflicts of interest, including Adams v.
Commissioner, 85 T.C. 359 (1985).
Mr. Seery subsequently filed
motions to withdraw as counsel in the Kersting project cases
(both test cases and nontest cases), citing concerns about a
possible conflict of interest.
The Court granted Mr. Seery's
motions.
By letter dated December 12, 1986, Mr. Kersting informed
Kersting program participants that Judge Goffe had "inferred"
that Mr. Seery might have a conflict of interest.
Although
Mr. Kersting denied that he was represented by Mr. Seery, he
stated that he and Mr. Seery had decided that it would be prudent
for Mr. Seery to withdraw as counsel.
Mr. Kersting further
stated that substitute counsel had been retained to represent
test case and nontest case petitioners alike.
D.
Entries of Appearance by Chicoine and Hallett
Following Mr. Seery's withdrawal, Mr. Bradt recommended that
Mr. Kersting hire Mr. Izen to serve as counsel for the test
- 52 cases.30
However, Mr. Kersting, with his son-in-law, an
attorney, Roger Moseley (Mr. Moseley), contacted Robert J.
Chicoine (Mr. Chicoine) and Darrell D. Hallett (Mr. Hallett)
(collectively Chicoine and Hallett), to determine whether they
would represent the test case petitioners at the Maui session.
On November 22, 1986, Mr. Kersting sent Mr. Hallett a
letter describing the Kersting programs.
Shortly thereafter,
Mr. Kersting interviewed Mr. Hallett in Hawaii.
On December 9,
1986, Chicoine and Hallett reached an agreement with Mr. Kersting
to represent the test case petitioners (other than the
Thompsons).
On December 12, 1986, Mr. Kersting wrote to Kersting
program participants informing them that Mr. Seery had withdrawn
as counsel and that Chicoine and Hallett had been retained.
At
the same time, either Mr. Kersting or Chicoine and Hallett
informed the test case petitioners that they would have to
provide Chicoine and Hallett with written authorization to enter
appearances in their cases.
Although Mr. Seery sent Chicoine and Hallett his files for
the test cases, most of the documents that Mr. Seery had intended
to use at trial remained in Mr. Kersting's possession.
By
letter dated December 19, 1986, Chicoine and Hallett reminded
Mr. Kersting that they needed all documents in the possession of
Mr. Kersting and Mr. Seery that pertained to the Kersting
programs in dispute in the Tax Court.
30
to 1981.
Mr. Bradt and Mr. Izen had been law partners from 1978
- 53 By letter dated January 7, 1987, Chicoine and Hallett
outlined the conditions underlying their agreement with
Mr. Kersting to represent the test case petitioners in the Tax
Court.
Chicoine and Hallett's letter states in pertinent part:
Our representation is conditioned upon the
following however:
1. We will represent only the individuals
selected as test cases and who request us to do so. We
are not representing or acting on behalf of any other
taxpayers or litigants who have invested in various
companies in which you are affiliated and who have
stipulated to be bound by the outcome of the litigation
or desire legal advice with respect to whether they
should accept the Internal Revenue Service's settlement
proposal.
2. All parties understand and agree that under
the circumstances, the Petitioners involved in the test
cases who have expressly authorized us to represent
them will be our clients and that we do not represent
you individually, although you have agreed with those
Petitioners that you will pay the legal fees to defer
[sic] the costs of their defense. We will discuss the
fee arrangement with each of the Petitioners in the
test cases and their perception of any possible
conflict of interest which we would require that they
waive.
3. It is understood that there will be no
restrictions on the advice which we may provide to our
clients and after review of the relevant facts and
documents, we are free to propose such settlements as
we may deem appropriate. We need not proceed with
trial in any situation if which we consider our
position to be indefensible or frivolous.
In early January 1987, Messrs. Chicoine and Hallett filed
entries of appearance as counsel in each of the test cases other
than the Thompson and Cravens cases.
As discussed in greater detail infra pp. 100-106, at the
time of Mr. Seery's withdrawal from the Cravens cases,
- 54 Mr. Cravens and Mr. McWade had agreed to a settlement of the
Cravens cases.
After reaching an agreement with Mr. McWade, Mr.
Cravens did not authorize Chicoine and Hallett to enter an
appearance in his cases.
E.
Evidentiary Issues
After undertaking to represent the test case petitioners,
Chicoine and Hallett decided to challenge their deficiency
notices on the ground that the search of Mr. Kersting's office in
January 1981 had been illegal.
Chicoine and Hallett thereupon
filed motions for leave to file amendments to the petitions and
lodged the amendments with the Court.
The amendments included
arguments that the materials seized by the Internal Revenue
Service during the search of Mr. Kersting's office should be
suppressed at trial of the test cases and that the burden of
proof and burden of going forward with evidence should be shifted
to respondent.
On January 14, 1987, the Court granted Chicoine
and Hallett's motions for leave to file amendments to the
petitions and subsequently directed respondent to file answers to
the petitions as amended.
1.
The Maui Session
Although the test cases were originally scheduled for trial
at the Maui session, the trial was delayed by the need to use the
Maui session to receive testimony and evidence on the evidentiary
issues raised by Chicoine and Hallett.
Mr. McWade and Henry E. O'Neill (Mr. O'Neill), another trial
attorney assigned to the Honolulu District Counsel Office,
- 55 appeared on behalf of respondent at the Maui session.
Mr. DeCastro appeared at the Maui session on behalf of the
Thompsons.
The Cravenses did not appear at the Maui session.
Following the Maui session, the Court ordered respondent and
petitioners, by May 18 and June 17, 1987, respectively, to file
opening and reply briefs addressing the evidentiary issues raised
by Chicoine and Hallett.
On motions by the parties, the Court
extended the dates for the filing of opening and reply briefs to
June 8 and August 10, 1987, respectively.
2.
Dixon I Opinion
On February 11, 1988, the Court issued its Dixon I opinion
rejecting Chicoine and Hallett's evidentiary arguments.
Specifically, the Court held that petitioners had failed to
establish standing to contest the Kersting search.
Dixon v.
Commissioner, 90 T.C. 237 (1988).
By order dated July 1, 1988, the Court set the test cases
for trial in San Diego, California, on January 9, 1989.
By order
dated October 24, 1988, the Court granted Mr. Izen's motion to
reconsider and set the test cases for trial in Honolulu, Hawaii,
on January 9, 1989.
V.
Kersting Disputes With Program Participants
Before the trial of the test cases, Mr. Kersting had
disputes, summarized below, with the Thompsons and the
Alexanders.
- 56 A.
The Thompsons
1.
The Bauspar Program
On August 13, 1979, the Thompsons purchased a condominium
unit in Wahiawa, Hawaii (the Wahiawa property), from Pacific
Universal Corp. (not a Kersting company).
On April 24, 1981, the
Thompsons entered a Kersting program known as Bauspar--not one of
the Kersting programs in dispute at the trial of the test cases-to effect the payoff of seller-provided financing on the Wahiawa
property.
The Thompsons executed a first mortgage and promissory
note reflecting a loan from Bauspar, Inc. (Bauspar), in the
principal amount of $80,000.
The Thompsons agreed to repay the
$80,000 Bauspar loan, with interest at 7 percent per year,
through monthly payments of principal and interest of $532.24 for
a 10-year period, followed by a balloon payment of $69,182.47.31
In conjunction with the Bauspar loan, the Thompsons agreed to
purchase $80,000 worth of Bauspar stock.
The Thompsons borrowed
$80,000 to purchase the Bauspar stock from another Kersting
company, Paragon Investments, Inc. (Paragon), at an annual
interest rate of 18 percent.
The Thompsons further agreed to
participate in a "savings program" by depositing $1,200 per month
into an account with Citizen's Financial, Inc. (Citizen's
Financial), another Kersting company.
On August 12, 1982, the Thompsons agreed to sell the Wahiawa
property to Kevin and Ada Shea for $122,500 by an "Agreement of
31
It appears that the Thompsons actually made monthly
payments of $535 to Bauspar.
- 57 Sale" under which the Thompsons apparently took back a purchase
money mortgage on the property.
The Thompsons continued to
participate in the Bauspar program until 1986 when the Sheas
decided to sell the Wahiawa property to a third party.
On January 30, 1985, Mr. Kersting sent Mr. Thompson a
schedule listing the interest payments that Mr. Thompson had made
during 1984 as follows:
Payee
Amount
Bauspar, Inc.
Paragon Investments, Inc.
Citizens Financial, Inc.
$6,420.00
9,611.04
14,400.00
Upon sale of the Wahiawa property by the Sheas in 1986,
Bauspar received a check in the amount of $75,511.74 in
satisfaction of the principal amount remaining due on the
Thompsons' loan from Bauspar.
2.
Deterioration of Thompson/Kersting Relationship
While working on the Thompsons' estate plan, Mr. Huestis
asked Mr. Kersting for an accounting of the Thompsons'
investments in Kersting programs.
By letter dated March 3, 1986,
Mr. Kersting responded by providing Mr. Huestis a summary list of
the Kersting programs that the Thompsons had participated in
during 1977, 1978, 1979, 1980, and 1981.
By letter dated
March 12, 1986, Mr. Huestis informed Mr. Kersting that the
Thompsons wished to terminate their participation in all Kersting
programs and obtain a complete accounting of their investments.
Mr. Huestis also requested that all future communications
- 58 regarding the matter be directed to Mr. Huestis rather than to
the Thompsons.
By letter dated March 17, 1986, Mr. Kersting complained to
Mr. Huestis about his "assertive approach" and said he would
continue to communicate directly with the Thompsons.
By letter
dated March 17, 1986, Mr. Kersting wrote to Mr. Thompson,
confirmed that he would terminate Mr. Thompson's programs, and
inquired whether Mr. Thompson still had any stock certificates
issued in connection with his participation in Kersting programs.
Mr. Kersting's letter also states that Mr. Thompson would incur
tax liability for capital gains that would be realized upon the
termination of his accounts in the Kersting programs.
On March 21, 1986, Mr. Huestis again wrote to Mr. Kersting,
stating that the Thompsons were disappointed with Mr. Kersting's
failure to respond to their requests or to assist them with the
tax problems arising from their participation in his programs.
By letter to the Thompsons dated March 25, 1986, Mr. Kersting
confirmed that he would liquidate their investments, as discussed
with Mr. Thompson in a recent telephone conversation.
Mr. Kersting requested that Mr. Thompson endorse all relevant
stock certificates and return them to Mr. Kersting so that the
proceeds from the sale of stock represented by such certificates
could be used to retire Mr. Thompson's debts to Kersting
companies.
By letter dated March 31, 1986, Mr. Kersting wrote to
Mr. Thompson and admitted that he was having difficulty
- 59 reconciling Mr. Thompson's Bauspar account because Earl LeMond,
Mr. Kersting's son-in-law and the manager of the Bauspar program,
did not keep reliable records.
Nonetheless, Mr. Kersting
prepared an accounting of Mr. Thompson's Bauspar account
indicating that Mr. Thompson had paid $90,769.72 under the
program and had received nontaxable dividends of $27,000 and
Federal tax and State income tax savings (presumably from
interest deductions) of $36,307.79 and $9,000, respectively.
Mr. Kersting further indicated that, in light of Mr. Thompson's
apparent dissatisfaction, he would waive the normal requirement
that the Bauspar program run for a 10-year period, allow
Mr. Thompson to terminate the program prematurely, and pay
Mr. Thompson $27,000 reflecting 3 years of "equity build-up" in
the program.
On the basis of his accounting, Mr. Kersting
concluded that Mr. Thompson would realize a net gain of $8,538.07
from the Bauspar program.
Mr. Kersting advised Mr. Thompson to
check his accounting carefully, and that, if necessary, Mr.
Kersting would make adjustments in Mr. Thompson's favor to avoid
a legal dispute.
On March 31, 1986, Mr. Kersting wrote a second letter to
Mr. Thompson stating that the Thompsons owed a total of $11,844
to Avalon Acceptance Corp., Aztec Acceptance Corp., Mahalo
Acceptance Corp., Lombard Acceptance Corp., and Candace, for
interest due on leverage notes during 1983 and 1984.
Mr. Kersting's letter states in pertinent part:
- 60 I will assume that you will take the position
that you should not be paying interest on notes which
produced deductions which you might not have used.
While this, of course, would not go well with a bank or
Credit Union (they would charge you interest whether
you use the deductions or not) I am willing to make
adjustments to your advantage. To get that underway I
suggest that you tell us which of the deductions were
claimed by you in 1983 and 1984.
*
*
*
*
*
*
*
To keep the spirit of accommodation alive and to remove
all elements of dissatisfaction we are quite willing to
lean over into your direction. It has troubled me
considerably that of all people you would be displeased
with our services.
On May 6, 1986, Mr. Thompson wrote to Mr. Kersting
requesting a full accounting for his participation in the Bauspar
program.
Mr. Thompson informed Mr. Kersting that the property
subject to the Bauspar mortgage had been sold.
Mr. Thompson also
said that he was reminding Mr. Kersting that, upon his retirement
in 1982, he had asked to terminate his participation in the
programs for which Mr. Kersting was now seeking interest payments
for leverage loans.
Beginning in June 1986, Mr. Thompson stopped making the
$1,200 monthly deposits to Citizens Financial as required under
the Bauspar program.
At the same time, Mr. Thompson ignored
Mr. Kersting's written requests to explain his failure to make
the deposits.
Further, on June 23, 1986, at the suggestion of
Mr. Huestis, the Thompsons retained John A. Chanin (Mr. Chanin),
an attorney practicing in Honolulu, to assist them in their
dispute with Mr. Kersting.
Mr. Chanin assigned the matter to his
associate, Keith Y. Yamada (Mr. Yamada).
- 61 On August 1, 1986, Mr. Yamada spoke with Mr. Kersting by
telephone and requested a detailed accounting of the amounts that
the Thompsons had paid to Bauspar and Citizen's Financial, as
well as a status report on the promissory notes executed by the
Thompsons in favor of Bauspar, Signet Financial, Inc., and
Paragon.
Following the telephone call from Mr. Yamada,
Mr. Kersting called Mr. Thompson.
During this conversation,
Mr. Thompson reminded Mr. Kersting that the Wahiawa property had
been sold.
Mr. Kersting stated that he would provide Mr. Chanin
with copies of the documents relating to Mr. Thompson's
participation in the Bauspar program as soon as Mr. Thompson
provided Mr. Kersting with a written authorization to release
them.
By letter dated August 23, 1986, Mr. Kersting notified the
Thompsons that he had turned their file over to Mr. Moseley for
collection and that he sensed that litigation was imminent.
Mr. Kersting's letter states in pertinent part:
Since the odds, however, are in favor of imminent
litigation I consider it to be my obligation to point
out to you the consequences:
The day after you have allowed your attorneys to file
suit I will declare all notes which you have executed
to our companies in default and begin collection
proceedings. We will make an effort to collect from
you not only the $11,844.00 of interest on promissory
notes of which we have sent you billings several times
we will also file suit to collect the principal of all
notes which we hold. The aggregate sum is well in
excess of $250,000.00, as you know.
I will also ask you to return to us the $40,000.00 we
advanced to you after the First Savings debacle. We
will start collection proceedings on the $75,000.00
- 62 note which you executed in favor of FEDERATED FINANCE
COMPANY to facilitate the acquisition of your stock in
First Savings & Loan Ass. We will ask you to pay a
pre-payment penalty on your mortgage on the house in
Wahiawa.
We will NOT arrange for you a capital gain in your
BAUSPAR HOLDINGS INC. stock which I had considered-even though not due you because of premature withdrawal
from the Plan--and we will NOT render assistance in
saving you capital gains taxes on the re-capture of
basis in your stock holdings.
We will NOT provide legal assistance free of cost to
you any longer in US Tax Court proceedings. You will
have to retain your own attorney to make an appearance
for you on February 9/1987 in US Tax Court.
By letter dated August 24, 1986, Mr. Kersting notified
Mr. Seery that he expected to be in litigation with the Thompsons
and directed Mr. Seery not to "render any services, at our
expense," to the Thompsons.
By letter dated August 28, 1986, Mr. Huestis notified
Mr. Moseley that he represented the Thompsons in connection with
their Kersting transactions and the pending Tax Court litigation.
Mr. Huestis advised Mr. Moseley to direct all future
communications regarding the Thompsons to Mr. Chanin.32
By letter dated September 5, 1986, Mr. Kersting again
notified Mr. Seery of his dispute with the Thompsons and
the likelihood of litigation.
Mr. Kersting included a copy
of Mr. Huestis' August 28, 1986, letter to Mr. Moseley.
32
As previously mentioned, this was around the time that
Mr. Seery began the process of withdrawing as counsel for the
Thompsons, following Mr. Huestis' notification to Mr. Seery that
the Thompsons were in the process of retaining substitute
counsel.
- 63 Mr. Kersting told Mr. Seery that he considered it "mandatory"
that the Thompsons be removed as test case petitioners.
On
September 24, 1986, Mr. Kersting again wrote to Mr. Seery,
reminding him of the need to remove the Thompsons from the list
of test cases.
During this period, Mr. Thompson began talking
with other Kersting program participants about filing a class
action lawsuit against Mr. Kersting.
On January 1, 1987, Mr. Kersting wrote to Bill Witthorne, a
Kersting program participant, requesting help in dealing with
Mr. Thompson.
Mr. Kersting's letter states in pertinent part:
Yet, I consider it important that someone would bring
home to Jack the dangers of the action he has in mind.
He has been hoodwinked by the attorneys out in
California and I think he is blind to the
ramifications. Can you think of anyone in California
who is close to Jack and willing to talk to him?
That same day Mr. Kersting wrote to Benness M. Richards, another
Kersting program participant, stating in pertinent part:
We have been unsuccessful over the last six months or
so to convince Jack that he will be better off with the
legal representation provided by us. Neither has
anyone be [sic] able to bring home to him that the IRS
does NOT make him a better deal than offered to all the
other Petitioners.
On March 10, 1987, Mr. DeCastro and Mr. Huestis informed
Mr. Thompson that Mr. Kersting would not return the Thompsons'
promissory notes.
Mr. DeCastro indicated that he wanted to
discuss the possible involvement of his firm in bringing legal
action against Mr. Kersting.
On April 10, 1987, Mr. Thompson wrote a letter to other
Kersting program participants, saying that Mr. Kersting had
- 64 deceived him.
In his letter, Mr. Thompson said that he had gone
to Mr. Kersting to reduce his tax liabilities but that he now
believed the cost to him would be great because the Internal
Revenue Service was challenging Mr. Kersting's programs.
Mr. Thompson suggested that the biggest worry for Kersting
program participants was Mr. Kersting's "ultimate weapon", the
promissory notes.
Mr. Thompson enclosed a copy of a letter that
he had received from Mr. Kersting as an example of what the
others might face.33
Mr. Thompson informed the other
participants that, although Mr. Kersting had promised to cancel
all promissory notes in exchange for the surrender of the
Kersting company stock that was purchased with the proceeds of
the primary loan, Mr. Thompson had tried to surrender his
Kersting company stock but Mr. Kersting had refused to cancel
Mr. Thompson's promissory notes.
Mr. Thompson indicated that
he no longer trusted Mr. Kersting, and that he had retained
Mr. DeCastro.
By letter dated May 5, 1987, Mr. Yamada advised Mr. Thompson
that a lawsuit against Mr. Kersting would have merit, and that a
class action lawsuit should be considered.
Around this time,
Mr. DeCastro had proposed to file suit on behalf of the Thompsons
against Mr. Kersting in Federal District Court.
33
Although the Court's copy of Mr. Thompson's Apr. 10,
1987, letter does not include a copy of a letter from
Mr. Kersting, we assume that Mr. Thompson circulated
Mr. Kersting's letter of Aug. 23, 1986.
- 65 On May 26, 1987, Mr. Huestis called Mr. DeCastro and learned
that, after Mr. Kersting had obtained a copy of Mr. Thompson's
April 10, 1987 letter, Mr. Moseley had written to Mr. DeCastro
on behalf of Mr. Kersting and proposed a settlement of the
Kersting/Thompson dispute.
During a later meeting that day with
Mr. Thompson, Mr. Huestis agreed to contact another lawyer in
Honolulu, Charles R. Kozak (Mr. Kozak), to discuss whether
Mr. Kozak might represent the Thompsons in a lawsuit against
Mr. Kersting.
On May 27, 1987, Mr. Huestis contacted Mr. Kozak on behalf
of the Thompsons.
Mr. Kozak informed Mr. Huestis that he had
represented two other Kersting participants (David L. Bigelow34
34
David L. Bigelow and Patricia L. Bigelow had
participated in the CAT-FIT program during the taxable years
1975 and 1976. In Bigelow v. Commissioner, T.C. Summary 1983-6
(docket No. 3147-78S), the Court held that the Bigelows were
entitled to interest deductions that they had claimed under the
CAT-FIT program, partly on the basis of evidence that the
Bigelows had successfully sued a related Kersting finance company
in State court. Because the Bigelows' case was tried under the
small tax case procedure, the case was not subject to appeal and
is not treated as precedent for any other case. See sec.
7463(b).
Mr. Kozak had represented Mr. Bigelow in a lawsuit against
Mr. Kersting for payment of the "equity build-up" in a mortgage
funding program (presumably Bauspar) following Mr. Bigelow's
termination of the program. Mr. Bigelow won the suit and
collected damages. According to Mr. Kozak, Mr. Bigelow had
prevailed by virtue of Mr. Kersting's promise not to enforce
notes that Mr. Bigelow had signed in connection with his
participation in other Kersting programs. Mr. Bigelow used
Mr. Kersting's written promise that he would not enforce
promissory notes to prevent Mr. Kersting from asserting the
principal on the notes as a defense or offset to Mr. Bigelow's
claim to the equity buildup in the mortgage funding program.
- 66 and Michael Provan35) and that he knew the Kersting programs and
how to locate Mr. Kersting's assets.36
On June 2, 1987,
Mr. Huestis agreed to send a copy of the Thompson file to
Mr. Kozak.
On the same date, Mr. Huestis notified Mr. Yamada
that the Thompsons did not plan to retain the Chanin firm to
bring suit against Mr. Kersting.
Messrs. Bigelow, Provan, and Thompson all asked Mr. Kozak to
investigate the filing of a lawsuit against Mr. Kersting.
On
August 6, 1987, Mr. Kozak wrote to Mr. Thompson and suggested
that there was a good chance of obtaining a large judgment
against Mr. Kersting through a class action lawsuit, but that
collection of any such judgment would be uncertain.
In addition,
Mr. Kozak's letter states in pertinent part:
As you know, Kersting is now embroiled with the
IRS on behalf of his clients. I recently had a
conference with Ken McWade, local counsel for the IRS.
He tells me the trial of these cases will be no sooner
than late Spring 1988. I suspect 12-18 months is a
more realistic date. Also McWade stated he is 100%
sure Kersting will be unable to show any "purposive"
function of his corporations other than to avoid taxes.
Several witnesses including yourself are available to
McWade to prove Kersting never had any intention of
enforcing the notes he had his clients execute. Also,
I am suspicious that Kersting's representation that his
35
Mr. Kozak had represented Mr. Provan when he had been
sued as a director of First Savings. The representation ended
with a settlement with the company that provided First Savings'
officers and directors liability insurance. Mr. Kozak did not
represent Mr. Provan in any tax controversies with the Internal
Revenue Service related to the Kersting programs.
36
As discussed in greater detail, infra pp. 115-116,
Mr. Kozak and his wife, Susan K. Kozak, had participated in one
or more of the Kersting programs that were the subject of this
Court's opinion in Pike v. Commissioner, 78 T.C. 822 (1982).
- 67 companies are making loans, leasing cars and factoring
accounts in any meaningful business sense is without
any merit.
Further, I believe we will find that Kersting did
not do many of the "house keeping" accounting and legal
matters which needed to be done to qualify his schemes
before the IRS, even if there was an arguable business
purpose position for his schemes under the tax code.
In my estimation, those clients of Kersting who
continue to be represented by Kersting's lawyers are
headed towards a nightmare. Interest continues to
mount on the taxes due. By the time the pilots finally
get a decision from the tax court, they will be in
terrible financial condition. Of course, they will
still have to pay the tax since bankruptcy will not
terminate their tax liability.
Those who are smart enough should disassociate
themselves from Kersting's lawyers now, obtain their
own counsel, offer their testimony as part of their
negotiations with the IRS and buy out as cheap as they
can now!
There is no evidence in the record that the Thompsons have
ever filed a lawsuit against Mr. Kersting or that Mr. Kersting
has ever filed a lawsuit against the Thompsons.
There is no
documentation in the record to support Mr. Thompson's statement
to Mr. Kersting in 1986 that in 1982 he had asked Mr. Kersting to
terminate Mr. Thompson's participation in the Kersting programs.
B.
The Alexander Dispute
As previously mentioned, Mr. Alexander first met
Mr. Kersting in Los Angeles in the early 1960's.
In the mid-
1970's, Mr. Alexander lent over $100,000 to Mr. Kersting to
assist him in the acquisition of Cosmopolitan Financial Corp.
Mr. Alexander's creditor's interest in Cosmopolitan evolved into
a stock interest in Charter Financial.
Mr. Alexander also lent
- 68 $80,000 to Mr. Kersting's subchapter S leasing corporations in
the 1970's.
In 1977, Mr. Alexander, a minority shareholder of First
Savings, met with Mr. Kersting to discuss the possible
acquisition of the company.
Mr. Alexander participated in the
acquisition of First Savings and added to his First Savings stock
holdings in the process.
Mr. Alexander participated in certain
Kersting programs at issue in Dixon II during the taxable years
1974 through 1977.
In 1980, Mr. Alexander brought suit against Mr. Kersting
in Hawaii State court seeking the repayment or return of
approximately $450,000 that Mr. Alexander claimed he had lent to
or invested with Mr. Kersting.
Mr. Kozak initially represented
Mr. Alexander in this litigation.
Mr. Kersting and/or his
companies eventually filed counterclaims in excess of $4 million
against Mr. Alexander.
Mr. Moseley represented Mr. Kersting in
the Alexander litigation.
In March 1982, Mr. Alexander received a telephone call from
Internal Revenue Service Special Agents George Scott and Mike
Duncan, who were interested in questioning Mr. Alexander
regarding Mr. Kersting's various programs.
The record does not
reflect whether Mr. Alexander ever agreed to be questioned by the
agents.
The Alexander/Kersting litigation eventually was submitted
to arbitration during a week-long proceeding in July 1987.
During the arbitration proceeding, Mr. Kersting discovered that
- 69 Messrs. Alexander, Kozak, and Matsumoto had contacted Mr. McWade
to discuss whether the Government would pay a finder's fee
for information pertaining to Mr. Kersting's programs.
Mr. Alexander's discussions with Mr. McWade on the subject of
a finder's fee are discussed in greater detail, infra pp. 106115.
In a letter dated July 24, 1987, Mr. Kersting brought his
dispute with Alexander to the attention of Chicoine and Hallett,
stating as follows:
Dear Darrell:
I have spent the better part of this week in
arbitration hearings concerning a case whereby we are
attempting to accomplish an offset of debt owed us by a
Mr. Denis Alexander against certain obligations we have
to him. The matter has been going on for more than six
years and has become sheer agony.
During the course of the proceedings, however, certain
matters came to the surface which will become apparent
to you as you will read the enclosed material. The
material will disclose a conspiracy between McWade,
DEnis [sic] Alexander, an accountant by the name of
Gilbert Matsumoto and an attorney by the name of
Charles Kozak.
Here are some short facts to illuminate the case:
DEnis [sic] Alexander was a long-time friend going back
more than 25 years, until we locked horns over the debt
referred to above.
Gilbert Matsumoto is an accountant who was for years
the tax preparer for our Finance Company in Aiea,
Federated Finance Company, and for about 10 to 14 of
our clients which we had referred to him. He had given
me an opinion with respect to the viability of the
SubChapter S concept which we employed in the mid-70s
for our Leasing Companies. He, in fact, did the filing
of SubChapter S qualification forms for us with the IRS
in Fresno, Calif. and did some of the Tax Returns. I
- 70 adapted the SubChapter S principles on the strength of
his advise [sic].
Charles Kozak is an attorney here in town who was at
one time a shareholder in one of our SubChapter S
Leasing Companies and also a participant in other
programs. He did some legal work for us in the mid-70s
in chasing a dead-beat by the name of Feliciano and he
obtained judgement for us. He became an adversary
after he had made no lease payments on a car which we
had leased to him which compelled us to repossess the
car. He was delinquent by more than one year. He has
stirret [sic] up trouble for me ever since.
These three characters now conspired with McWade to
initiate criminal proceedings again against me and, as
you will read, already discussed among themselves how
to divide the "finders fee" (more precisely the Judas
ducats) which they expected to receive from IRS. As we
took Alexanders [sic] testimony this week it became
apparent to Kozak that he had acted unethically and he
read a statement into the records that "he had advised
his client (Alexander) not to engage in reporting me to
the IRS in order to extract from me a settlement of his
claims" which, of course, is self-defeating since he
was an active participant in the scheme.
I have reason to believe that all of this led nowhere.
If even entrapment and subsequent raid on our premises
did not yield the evidence for the CID characters to
take me out of circulation the Kozak / Alexander /
Matsumoto / McWade conspiracy had no prospect of
success. More than a year has gone by since these rats
tried to make money by setting me up for execution.
I will assume that this incident will become a piece
of the mosaic which should be made known to the US Tax
Court Judge in support of my contention that IRS and
it's [sic] representatives have conspired to ruin my
business and inflict harm on me personally, one way or
another.
Following the arbitration hearing, Mr. Moseley filed a
complaint with the Supreme Court of the State of Hawaii, Office
of Disciplinary Counsel (HODC), accusing Mr. Kozak of conflict of
interest and of attempting to extort money from Mr. Kersting in a
civil suit.
On March 17, 1988, Mr. Kozak submitted a written
- 71 response to the HODC in response to Mr. Moseley's complaint.
Mr. Kozak alleged that he had been offered inducements by the
Internal Revenue Service in exchange for his cooperation in an
Internal Revenue Service investigation of Mr. Kersting,
suggested that HODC should contact Mr. McWade, denied that he
used the threat of Internal Revenue Service litigation against
Mr. Kersting, and denied any conflict of interest.
On April 12,
1988, Mr. Kozak wrote another letter to HODC stating that the
Internal Revenue Service had agreed to pay Mr. Kozak and
Mr. Alexander for their cooperation in an Internal Revenue
Service investigation of Mr. Kersting.
At the evidentiary
hearing in this proceeding, Mr. Kozak testified that his
statements to HODC that the Internal Revenue Service had agreed
to pay him for cooperation in an investigation of Mr. Kersting
were false.
On July 12, 1988, the arbitrator released his Arbitration
Decision and Award denying all claims and counterclaims between
Messrs. Alexander and Kersting.37
The arbitrator's decision
37
Following the issuance of the arbitration decision, the
Alexanders claimed a net operating loss (NOL) on their 1988 tax
return in the amount of $321,000 identified as amounts "expended
for the purpose of starting new businesses deemed to be
unretrievable by the American Arbitration Association". The
Alexanders later claimed an NOL in the amount of $360,260 on
their 1990 tax return and an NOL carryforward of $201,955 and a
loss "due to fraud" in the amount of $129,000 on their 1991 tax
return. The Alexanders' 1991 tax return included the following
statement:
The loss was $450,000. $321,000 was claimed on the
1988 returns. $129,000 was not claimed because
(continued...)
- 72 turned largely on the lack of credibility of both parties.
The record does not reflect the outcome of Mr. Kersting's
complaint filed with HODC against Mr. Kozak.
C.
Collection Actions
In Dixon II, the Court described Mr. Kersting's 1980 dunning
letter to more than 30 program participants and several lawsuits
brought during the period 1983-86 in the names of Kersting
corporations against Kersting program participants to collect
amounts purportedly due on promissory notes.
See Dixon II, 62
T.C.M. (CCH) at 1466-1467, 1505-1506, 1991 T.C.M. (RIA), at 913007 to 91-3008, 91-3048 to 91-3050.
Summarized below are the
Court's findings and conclusions in Dixon II regarding the
collection lawsuits.
1.
Steve Hane
In 1983, a Kersting company, Atlas Funding, commenced an
action on a $30,000 renewal primary note for a stock subscription
plan against Kersting program participant Steve Hane.
The Court
noted that the Hane litigation was the only example in the record
37
(...continued)
recovery was expected in the future. In 1991 the
assets on which the recovery was anticipated
disappeared because the corporation was absorbed and
ceased to exist.
Upon examination of the Alexanders' returns for 1990 and
1991, the Commissioner disallowed the claimed NOL's and fraud
loss. After the Alexanders agreed to these adjustments, the
Commissioner issued a notice of deficiency to the Alexanders
determining accuracy-related penalties attributable in part to
the disallowed losses. In Alexander v. Commissioner, T.C.
Summary 1997-80 (docket No. 8948-95S), the Court sustained the
Commissioner's determinations.
- 73 of litigation on a primary note.
The Court concluded that the
evidence of the Hane litigation was inconsequential because of
the lack of any testimony about the matter and the fact that
Atlas Funding dismissed the action voluntarily after obtaining a
default judgment.
2.
Carl Mott, George Vermef, and Robert Peterson
In Dixon II, the Court found that Kersting corporations
pursued collection lawsuits in 1985-86 on leverage loans against
Kersting program participants Carl Mott, George Vermef, and
Robert Peterson.
The Court noted that while Carl Mott had been
sued only for interest on leverage loans, Messrs. Vermef and
Peterson had been sued for both interest and principal on
leverage loans.
The Court found that there was no explanation in
the record how Messrs. Vermef and Peterson could have owed
principal on leverage loans that would be consistent with the way
the Kersting programs were intended to operate nor with the way
that they apparently actually operated.
Further, the Court found
that the judgments entered against Mr. Vermef were vacated after
the parties agreed to settle the cases and that a default
judgment entered against Mr. Peterson later was set aside on
Mr. Peterson's motion.
The Court summarized its conclusions
regarding collection activities and litigation as follows:
Five Kersting corporations commenced actions
against Carl Mott based upon a year of unpaid interest
on 15 leverage notes, but the principal amounts of the
notes were not in issue. The record is replete with
copies of checks, drawn on personal bank accounts other
than Liberty Bank or Hawaii National Bank, that
petitioners used to pay interest on leverage notes.
- 74 Respondent does not dispute that Kersting insisted on
these interest payments, but maintains that to the
extent they were made they must be characterized as
fees to Kersting for providing tax deductions.
Consequently, that Carl Mott allegedly failed to pay
interest on leverage notes is of no significance to the
substance of his or anybody else's leverage loans.
*
*
*
*
*
*
*
As illustrated by Kersting's pay-or-else letter
to over 30 clients on September 25, 1980, and his 1986
correspondence with the Thompsons, his overriding
concern was to be compensated by means of leverage loan
interest. It was this amount that even he often
referred to as a "fee" or a deductible "cost" of tax
deductions. In encouraging clients by means of the
September 25, 1980, letter to "discharge the debt to
which you are a party," he sought only small amounts
that could not have represented typical primary or
leverage loans. His letters to the Thompsons indicate
that he only threatened or pursued collection of
principal obligations when the investor neglected or
refused to pay leverage loan interest. This rare
occurrence, which Kersting did not testify he either
intended or expected, is not sufficient to transform
any of petitioners' loans from Kersting corporations
into genuine recourse indebtedness.
Dixon II, 62 T.C.M. (CCH) at 1505-1506, 1991 T.C.M. (RIA), at 913049 to 91-3050.
VI.
Settlements
A.
Internal Revenue Service Policy
1.
National Office Position
After a tax shelter project is created and a project
attorney and a project Appeals officer are appointed, an official
project settlement offer is determined by the project Appeals
officer, the project attorney, and District Counsel.
The project
attorney and project Appeals officer review the strengths and
weaknesses of the particular tax shelter and evaluate the hazards
- 75 of litigation to determine an appropriate project settlement
offer.
Upon determination of the project settlement offer, the
terms of the offer are reported to the Tax Shelter Branch in the
National Office for dissemination to Internal Revenue Service
field offices (particularly the examination and appeals
functions) throughout the country to ensure that similarly
situated taxpayers are treated consistently.
Once a tax shelter project is assigned to a particular
District Counsel office, that office has the authority to settle
any individual case in the project.
District Counsel generally
is expected to adhere to the official project settlement offer.
Nevertheless, District Counsel has the authority in special
circumstances to settle individual tax shelter project cases on a
basis different from the project settlement offer.
For example,
District Counsel could deny a project settlement offer to the
shelter promoter or a participant who had helped to market the
program.
In addition, District Counsel might eliminate an
addition to tax (such as negligence) because of the participant's
lack of education or sophistication in financial matters.
District Counsel can alter or modify an official project
settlement offer without prior approval of the National Office.
However, District Counsel is required to notify the Tax Shelter
Branch of any change or modification to the official project
settlement offer in order to allow the Tax Shelter Branch to
disseminate the revised offer to Internal Revenue Service offices
throughout the country.
- 76 The National Office did not maintain a policy prohibiting
the settlement of a test case.
However, the Commissioner's
practice of withdrawing project settlement offers once the
project test cases have been set for trial would serve to bar
settlements in test cases and nontest cases alike.38
2.
Regional Counsel
Benjamin C. Sanchez (Mr. Sanchez) served as Regional Counsel
for the Western Region during the period in question.
His view
of District Counsel's settlement authority in tax shelter cases
differed from the National Office view.
In Mr. Sanchez' view,
District Counsel had authority to settle tax shelter project
cases only on the basis of the official project settlement offer.
Mr. Sanchez believed that District Counsel was obliged to adhere
strictly to the official project settlement offer because of the
overriding need to ensure consistent treatment of tax shelter
project cases.
Although Mr. Sanchez acknowledged that District
Counsel technically had authority to settle a tax shelter project
case on a basis different from the official project settlement
offer, Mr. Sanchez believed that it would be improper to do so.
In his view, disciplinary or other adverse career consequences
might follow if District Counsel deviated from the official
project settlement offer in settling a case.
38
Of course, District Counsel might be reluctant to settle
a test case at a time that removal of the case from the test case
array would require delay in the trial to allow the parties to
select a replacement case.
- 77 Mr. Sanchez expected that he would be informed by District
Counsel of settlements in tax shelter project cases that deviated
from the official project settlement offer.
B.
Official Kersting Project Settlement Offer (7-Percent
Reduction of Deficiency or Out-of-Pocket Expenses)
Between January 1982 and mid-1986, the terms of the official
Kersting project settlement offer were stated as follows:
You will be allowed your actual out-of-pocket
expenses, in essence, the interest you actually paid
to Henry Kersting on the prepayment loan, or leverage
loan, which amount equals approximately 7% of the
determined deficiencies in most cases. In addition,
if you reported capital gain income from the Kersting
transactions, or recaptured the difference between your
adjusted basis in the stock and your outstanding
indebtedness, then an appropriate adjustment will be
made to reflect this fact. In addition, if you are
involved in a leasing plan, to the extent there are
additional allowable I.R.C. Section 162 expenses which
were not claimed on the return, an appropriate
allowance will be made for settlement purposes. If
you were involved in the Uniform Gift to Minors Act
program, referred to as KAT-FIT (sic), to the extent
you can establish compliance with the Clifford Trust
rules, then an appropriate allowance for the deductions
will be made. The government will concede the
negligence penalties, I.R.C. Section 6653(1) and I.R.C.
Section 6653(a)(2), as well as the I.R.C. Section
6621(c) interest.
The 7-percent reduction of the deficiency reflected a deduction
equal to an average of the actual out-of-pocket expenses in
approximately 25 Kersting project cases.
For this purpose, the
Commissioner treated the "interest" paid on Kersting leverage
loans as the out-of-pocket expense.
From respondent's
- 78 perspective, the 7-percent settlement offer was equivalent to
allowing a deduction for a theft loss in the year of payment.39
Under the 7-percent settlement offer, the Commissioner
would:
(1) Concede the negligence addition to tax and increased
interest imposed on tax-motivated transactions pursuant to
section 6621(c); (2) concede an annual deduction under section
162 or 212 to leasing program participants for expenses that
exceeded the out-of-pocket adjustment; (3) concede the deficiency
in full to participants in the CAT-FIT program who could provide
information on how the funds paid to the minor child were used
and establish that such use did not give rise to constructive
receipt of income by the parents; and (4) make appropriate
adjustments if the taxpayer had reported capital gains upon the
surrender of stock certificates to Mr. Kersting.
The purpose of
these concessions and adjustments was to provide similar
treatment of all Kersting program participants who wished to
settle their cases.
C.
Deviations From Official Project Settlement Offer
1.
Modified 7-Percent Settlement Offer
Between April and September 1986, Mr. McWade and Mr. Seery
conducted settlement negotiations that led Mr. McWade to offer a
settlement that deviated from the official project settlement
39
Respondent's position represented a concession insofar
as the allowance as a deduction of a theft loss of payments
induced by misrepresentation is postponed until the year of
discovery. See sec. 165(e); Bellis v. Commissioner, 61 T.C. 354,
357 (1973), affd. 540 F.2d 448 (9th Cir. 1976).
- 79 offer in one significant respect.
Specifically, by September
1986, Mr. McWade and Mr. Seery had agreed to modify the 7-percent
settlement offer to incorporate a new feature they called the
"shelter burnout" that would apply in cases involving more than 1
taxable year.
The shelter burnout feature grew out of Mr.
Seery's contention that Mr. Kersting's programs could be viewed
as a tax deferral mechanism.40
Mr. McWade agreed with Mr. Seery,
for settlement purposes, to allow a shifting of the initial
year's deficiency to a later year as a "shelter burnout".
For
example, in a case involving 2 taxable years, the taxpayer's
liability for statutory interest under section 6601 was computed
under the modified 7-percent settlement offer by treating the
taxpayer's tax liability for the earlier of the 2 years as having
been incurred on the due date for payment of tax for the later
year.
Under this approach, the total amount of the taxpayer's
underlying tax deficiencies remained the same, but the taxpayer's
liability for interest on the deficiencies was reduced by the
amount of such interest that otherwise would have accrued on the
deficiency for the earlier year of the 2-year period.
Variations
of this approach were used in cases involving more than 2 taxable
years.
40
The modified 7-percent settlement offer negotiated by
In Dixon II, the Court considered and rejected the
argument that Mr. Kersting's programs resulted in mere tax
deferral. The Court arrived at this conclusion through a
detailed analysis of the Cravenses' tax returns for 1979 and
1980. See Dixon II, 62 T.C.M. (CCH) at 1483-1484, 1991 T.C.M.
(RIA), at 91-3026.
- 80 Mr. Seery and Mr. McWade provided that the Commissioner would
settle any additions to tax for fraud on a case-by-case basis.
By letter dated September 29, 1986, Mr. Seery informed
Kersting program participants of the terms of the modified 7percent settlement offer and suggested that they give serious
consideration to the proposal.
Mr. McWade informed Mr. Seery
that, because the trial of the test cases had been set for
February 1987, the modified 7-percent settlement offer would be
withdrawn on December 31, 1986, and that Kersting program
participants interested in accepting the settlement should
contact Mr. McWade by November 10, 1986, in order to allow time
to complete the necessary computations before the withdrawal of
the offer.
On October 10, 1986, Mr. Kersting issued a letter to
Kersting program participants in which he characterized the
modified 7-percent settlement offer as "grossly inadequate."
Messrs. Sims and McWade did not notify the National Office,
Regional Counsel, or the Appeals Office that they had
incorporated the burnout feature in their offer to settle
Kersting project cases.
2.
20-Percent Settlement Offer
Between September and December 1986, Mr. McWade and Mr. Sims
began to offer 20-percent settlements that were based on the same
general approach as their modified 7-percent settlement offer
that included the burnout feature.
The 20-percent settlement
approach originated in late 1986 in separate negotiations between
- 81 Mr. Sims and Mr. Chicoine and between Mr. McWade and
Mr. DeCastro.
The enhanced 20-percent settlement offer reflected
the perceptions of Messrs. Sims and McWade that the evidentiary
issues raised by Chicoine and Hallett increased respondent's
risks of litigation.
The 20-percent settlement offer was not disseminated in
writing by either Mr. Sims or Mr. McWade.
The existence of the
20-percent settlement offer became known, if at all, through a
combination of Mr. Kersting's letters to program participants
and calls that Mr. McWade received from Kersting program
participants.
Messrs. Sims and McWade did not request approval
from or otherwise inform the National Office, Regional Counsel,
or the Appeals Office before making the 20-percent settlement
offer.
Following the February 1987 Maui session, the Honolulu
Appeals Office once again began to offer Kersting program
participants a deduction for their cash out-of-pocket expenses,
or if substantiation was not available, a reduction of the
deficiency by 7 percent, with a waiver of the additions under
section 6653(a)(1) and (2).
The Honolulu Appeals Office did not
learn that Mr. McWade had negotiated 20-percent settlement offers
until mid-1988, following issuance of the Court's opinion in
Dixon I.
At that time, the Honolulu Appeals Office determined
not to extend such offers because it saw no reason to deviate
from the official 7-percent project settlement offer.
- 82 3.
Negotiations for 50-Percent Settlement Offer
In January 1987, Messrs. Sims and Chicoine continued their
efforts to negotiate a settlement of the Kersting project cases.
Initially, their discussions concerned a higher percentage
settlement if Mr. Kersting would agree to quit the tax shelter
business.
They eventually abandoned their discussions to link
the settlement offer with Mr. Kersting's future conduct.
By letter dated January 16, 1987, Mr. Chicoine notified
Mr. Kersting that he believed he had arrived at an agreement with
Mr. Sims to settle all the Kersting cases docketed in the Tax
Court by allowing 50 percent of the claimed interest deductions.
Mr. Chicoine's letter further states that Chicoine and Hallett
would agree to represent Kersting program participants desiring
to settle their cases on these terms for a flat fee of $550 per
case.
On January 19, 1987, Mr. Kersting wrote a letter to program
participants stating that a 50-percent settlement had been
negotiated.
Mr. Kersting recommended that the 50-percent
settlement be accepted; he included with his letter a form for
program participants to use to authorize Chicoine and Hallett to
represent them for purposes of settlement.
As a result of
Mr. Kersting's letter, approximately 300 Kersting program
participants contacted Chicoine and Hallett seeking
representation.
- 83 In the meantime, Mr. Sims consulted Barbara Leonard, Deputy
Regional Counsel for the Western Region.
She directed him to
terminate negotiations based upon a 50-percent settlement.
Upon learning of Mr. Kersting's letter, Mr. DeCastro called
Mr. Chicoine to inquire about the terms of the purported 50percent settlement.
Mr. DeCastro stated that the terms of the
purported settlement were better than the terms he had
received for his clients and that he intended to attempt to
obtain the same terms for his clients.
During his conversation
with Mr. Chicoine, Mr. DeCastro threatened to "make trouble" for
Mr. Chicoine unless he referred clients residing in California to
Mr. DeCastro for further representation.
Mr. Chicoine flatly
rejected Mr. DeCastro's proposal.
Following the release of Mr. Kersting's January 19, 1987,
letter, Mr. Sims received numerous telephone calls from Kersting
program participants and attorneys seeking to accept the 50percent settlement.
Following his conversation with
Mr. Chicoine, Mr. DeCastro called Mr. Sims to express concern
that Mr. Chicoine's clients might obtain more favorable
settlements than the settlements offered to Mr. DeCastro's
clients.
By letter to Mr. Chicoine dated February 4, 1987, during the
week immediately preceding the Maui session, Mr. Sims denied that
he had agreed to a 50-percent settlement of the Kersting project
cases.
Mr. Sims' letter states in pertinent part:
- 84 1. I have not settled any of the Kersting cases
with you.
2. The government has not made any new, blanket
offer to settle these cases (other than our old 7%
offer); nor has the government made any offer to wholly
or partially concede any of the issues presented by
these cases. To the extent that you may disagree with
this statement, any such offer of concession that you
believe has been made by me or any other government
official is hereby withdrawn.
3. We do not have a workable basis for settlement
of any case or any group of cases. If you should
attempt to represent to the Court that you have such a
basis, either in order to obtain a continuance of the
trials in this matter or to attempt to force the
government into unagreed-to settlements or concessions,
I will dispute this firmly.
Before the start of the Maui session, Judge Goffe held a chambers
conference with Messrs. Chicoine, Hallett, Sims, McWade, O'Neill,
and DeCastro.
Although Mr. Chicoine told Judge Goffe that the
parties had reached a basis of settlement, Mr. Sims denied that
there was a settlement.
Mr. Sims said that he had "pulled
the plug" on a proposed 50-percent settlement because
Mr. Kersting had interfered with the negotiations.
4.
Revival of 20-Percent Settlement Offer
During spring 1987, Mr. Chicoine continued to explore with
Mr. McWade the possibility of a global settlement.
By letter
dated April 13, 1987, Mr. Chicoine provided Kersting program
participants with a detailed status report addressing
developments at the Maui session as well as settlement
negotiations.
Mr. Chicoine's letter also stated that the firm's
representation of nontest case taxpayers was not intended to
extend to general representation in all matters but was limited
- 85 to the acceptance of an Internal Revenue Service settlement
offer.
On April 16, 1987, Mr. Chicoine wrote to Mr. Kersting and
confirmed that he would be meeting Mr. McWade in Hawaii the
following week to discuss the possible settlement of six cases.
Mr. Chicoine warned Mr. Kersting not to address the subject of
the status of settlement negotiations in his letters to Kersting
program participants, inasmuch as his comments could be
detrimental to such negotiations.
On or about April 27, 1987,
Mr. Chicoine informed Mr. Kersting that he would recommend that
Kersting program participants accept a 20-percent settlement
offer.
By letter dated May 22, 1987, Mr. Kersting provided
Mr. Hallett with information pertaining to a purported 30-percent
settlement negotiated by Mr. DeCastro on behalf of Benness M. and
Jane Richards.41
Mr. Kersting stated that he was attempting to
obtain information respecting additional settlements negotiated
by Mr. DeCastro.
Between May 1987 and February 1988,
Mr. Kersting wrote no fewer than seven letters to Chicoine and
Hallett strongly objecting to their communication of a 20-percent
settlement offer to Kersting program participants.
41
In his
In Richards v. Commissioner, T.C. Memo. 1997-149,
supplemented by T.C. Memo. 1997-299, affd. without published
opinion 165 F.3d 917 (9th Cir. 1998), we observed that the
settlement may have been detrimental to Mr. and Mrs. Richards
insofar as the original deficiency had been computed using an
excessive tax rate (70 percent) and may have been based in part
upon the disallowance of legitimate non-Kersting interest
deductions. See supra p. 27.
- 86 May 22, 1987 letter, Mr. Kersting objected to Chicoine and
Hallett's recommendation of a 20-percent settlement in pertinent
part as follows:
As I have done several times now I ask you again NOT to
communicate to anyone of my friends a prospect of a 20%
settlement. The 50% flop has left a $40,000.00 to
$50,000.00 scar with us. It was a lesson I will take
with me to the other side. I trust that you have
reconsidered by now your position in the matter and
that you will NOT go into an adverse stance to me and
my enterprises. I assure you that the jolt of April
27th has not worn off yet.
On June 10, 1987, Mr. Kersting forwarded to Mr. Chicoine a
letter that he had received from Mr. DeCastro pertaining to a
settlement that Mr. DeCastro purportedly negotiated on behalf of
Boyd S. and Jeannette F. Proctor.
By letter dated June 16, 1987,
Mr. Chicoine responded to Mr. Kersting, stating that he was
satisfied that the Proctors did not receive a settlement in
excess of 50 percent as Mr. Kersting had suggested because the
figures in question did not include the Proctors' liability for
statutory interest.
Mr. Chicoine concluded that the settlement
was in the range of a 14-percent reduction of the Proctors'
deficiency.
On November 4, 1987, Mr. Kersting sent Mr. Hallett a letter
which states in pertinent part:
Here I asked you about a year ago to defend my
friends, here I had high hopes and reasonable
expectation that you would work with us, that we would
work on consensus and to the common benefit of my
friends and here I find that you not only do not care
to do that, you are actually moving into an adversary
position. And this after I have paid you an enormous
amount of legal fees and after I have disciplined
myself over and over again to keep my temper as I
- 87 observe a widening rift between the attorneys who are
supposed to work for us and who are, instead, looking
after their strangly [sic] perceived protection from
liability. My interest in these proceedings and what
I consider to be the best interest of my friends is
arrogantly overlooked and we are, if your scheme of
things would prevail, relegated to onlookers to a
spectacle for which we are compelled to pay but in
which we are not allowed to take part. It is simply
absurd.
On January 12, 1988, Mr. Kersting issued a letter
encouraging nontest case Kersting program participants who had
paid $550 to Chicoine and Hallett for representation in the
settlement process to "recall your funds".
By letter dated January 20, 1988, Mr. Chicoine notified the
test case petitioners represented by his firm that Mr. McWade was
offering a 20-percent settlement.
Mr. Chicoine's letter states
in pertinent part:
Mr. McWade has stated that you may settle your case
along the grounds set forth above. Since you are a
test case, however, you will not be permitted to
withdraw if you wish to enter into the settlement
proposed. Accordingly, we would enter into an
agreement with Mr. McWade that regardless of the
outcome of the trial, you would be allowed the
settlement. Thus, if the case were lost in its
entirety, your tax deficiency would be calculated in
accordance with the settlement.
By letter dated January 22, 1988, Mr. Hallett informed
Mr. Kersting that Chicoine and Hallett were seeking an opinion
from an expert on legal ethics whether it would be appropriate
for the firm to accept new clients seeking to settle Kersting
project cases.
However, Mr. Hallett stated that the firm would
continue to inform its existing clients regarding the status of
settlement discussions.
- 88 By letter dated January 29, 1988, Mr. Chicoine sent
Mr. Kersting copies of proposed stipulated decisions reflecting
settlements that Mr. Chicoine had negotiated with Mr. McWade in
three Kersting cases.42
Mr. Chicoine stated that Chicoine and
Hallett were obliged to inform all Kersting program participants
who had retained his firm that Mr. McWade was continuing to offer
settlements despite Mr. Kersting's misrepresentations in his
letters to Kersting program participants that no settlement was
being offered.
By letter dated February 5, 1988, John A. Strait, Associate
Professor of Law at the University of Puget Sound School of Law
(Professor Strait), responded to Chicoine and Hallett's request
for an expert opinion regarding their ethical obligations as
counsel in the Kersting project.
Professor Strait advised
Chicoine and Hallett that the firm did not have an attorney/
client relationship with, or owe attorney/client duties to,
Mr. Kersting, but that Chicoine and Hallett did have an
attorney/client relationship with the test case petitioners as
well as the nontest case Kersting program participants who had
sent Chicoine and Hallett the $550 retainer and authorization
forms.
Concerning the nontest case clients, Professor Strait
concluded that Chicoine and Hallett were obliged to "evaluate
settlement proposals and to transmit to them your recommendation
42
Mr. Chicoine's letter identified the taxpayers as
Muller, Lipsky, and Mellows. The record does not reflect the
terms of the settlements in these cases.
- 89 with the explanation of what the options might be as to the
desirability of accepting any settlement proposal."
On February 6, 1988, Mr. Kersting wrote to Mr. Hallett
stating in pertinent part:
I take it from our phone conversation yesterday that
you are intent now to trigger the melt-down on me and
our corporations with which you have threatened me now
for months. And if I have absorbed all this correctly,
you will do this mainly out of concern that some of my
friends might sue you at some time down the line if you
do not advise them of a "settlement" which you perceive
to be available.
The bitter irony of all this is that there was only a
remote possibility that anyone of my friends would sue
you. If you go through with your threat to cause a run
on us you will have THE CERTAINTY that there will be
litigation. It will be hell after this.
On February 8, 1988, Mr. Kersting wrote a letter to Kersting
program participants warning them that Chicoine and Hallett soon
would circulate the details of a 20-percent settlement offer.
Mr. Kersting urged Kersting program participants not to hire
Chicoine and Hallett for purposes of settlement and instead to
await the Court's decision regarding the evidentiary issues
raised by Chicoine and Hallett on behalf of the test cases.
During this period, Mr. Kersting threatened to sue Chicoine and
Hallett if they reported the settlement offer.
On February 9, 1988, Mr. Chicoine issued two letters, one
addressed to the firm's clients and one addressed to Kersting
program participants who had contacted Chicoine and Hallett
regarding representation.
These letters served as status reports
on the Tax Court case and settlement negotiations.
Mr. Chicoine
- 90 reported that Mr. McWade had offered to settle docketed Tax Court
cases in accordance with the previously described 20-percent
settlement offer, recommended that program participants seriously
consider the settlement, and suggested that those who desired to
settle on these terms should contact Chicoine and Hallett.
On February 20, 1988, Mr. Kersting wrote to Chicoine and
Hallett stating in pertinent part:
"I hereby revoke your
appointment as counsel for the test cases".
On February 23, 1988, Mr. Chicoine wrote to Mr. McWade
seeking a 20-percent settlement on behalf of test case
petitioners Terry D. and Gloria K. Owens.
Mr. Chicoine's letter
states in pertinent part:
Mr. Owens understands that not all cases will settle
and you wish to proceed to trial with some test cases.
It is hoped that under the circumstances he may be
withdrawn as a test case. If this is not possible,
he still wishes to settle the case and enter into an
agreement which will permit him to settle the case
regardless of the outcome of the trial.
Mr. and Mrs. Owens subsequently decided that they would not
continue efforts to settle their case.
In early March 1988, Chicoine and Hallett began receiving
requests from Kersting program participants for return of the
$550 retainer fee.
Although Chicoine and Hallett returned the
full amount of the fee to all those who requested it, they were
informed that they might be billed for a "minimal amount"
reflecting the firm's costs associated with the opening of files
and issuance of status reports.
- 91 On March 9, 1988, Mr. Kersting issued a letter to program
participants characterizing Chicoine and Hallett as "scoundrels",
and stating that he had fired them and retained Mr. Izen to
represent the test cases (excluding the Thompsons and the
Cravenses).
By letter dated April 22, 1988, Mr. Chicoine notified
Kersting program participants that the Court had ruled in the
Government's favor in Dixon I; he restated his support for the
20-percent settlement offer described in his February 9, 1988,
letter and revealed that, because of a disagreement with
Mr. Kersting, Chicoine and Hallett would withdraw as counsel for
the test cases.43
Mr. Kersting later carried out his threat to sue Chicoine
and Hallett for legal malpractice.
Mr. Izen served as an expert
witness for Mr. Kersting in his lawsuit against Chicoine and
Hallett.
By letter dated April 8, 1988, Mr. McWade notified
Mr. DeCastro that, after June 15, 1988, respondent would no
43
Coincidentally, on Apr. 20, 1988, Mr. DeCastro wrote a
letter to a client, James Losey, expressing similar sentiments in
favor of settlement of the Kersting cases. After outlining the
deadlines that Mr. McWade had set for the acceptance of
outstanding settlement offers, Mr. DeCastro's letter states in
pertinent part:
There is now an urgent need for your friends and
acquaintances to consult their legal counsel and
seriously consider settling their case with the IRS.
The evidence continues to build against the taxpayers
in these cases and despite Mr. Kersting's assurances,
we feel the trial will be won by the IRS. The result
would be very serious for the taxpayers.
- 92 longer consider settlements, other than on the basis of allowing
out-of-pocket expenses, and that out-of-pocket settlements would
no longer be available after October 3, 1988.
By memorandum
dated October 19, 1988, the Acting Chief of the Tax Shelter
Branch notified the Assistant Commissioner for Examination (with
copies to the Director of the Appeals Office, Mr. McWade, and
several National Office executives) that, because the Kersting
test cases had been set for trial in January 1989, the
Kersting project settlement offer would be withdrawn, effective
October 28, 1988.
D.
The Thompson Settlement
1.
Initial Thompson Settlement Agreement
In early December 1986, Mr. McWade and Mr. DeCastro
discussed settlement of the cases of a number of Mr. DeCastro's
clients, including the Thompsons.
Mr. Sims was aware of the
McWade-DeCastro discussions when he also met with Mr. DeCastro in
December 1986 at the Honolulu District Counsel Office and
generally discussed with Mr. DeCastro settlement arrangements for
the Thompson cases.
On December 23, 1986, Mr. McWade mailed a letter to
Mr. DeCastro enclosing proposed decision documents for the
Thompsons as well as several other taxpayers with cases before
the Court.
Mr. McWade's letter states in pertinent part:
Dear Mr. DeCastro:
Enclosed herewith are the Decision documents, as
per our conference, in the above-captioned cases.
Please sign the original and one copy of the Decision
document, in the space provided, and return them to
- 93 this office for signing and filing with the Court.
remaining copy is for your records.
The
As previously indicated, the Decision documents in
John R. and Maydee Thompson will not be filed with the
Court until the Decision becomes final in the test
cases. In the interim, the Thompsons can make an
advance payment, as discussed at our conference, and
stop the accrual of any additional liability for
interest.
In response, on December 30, 1986, Mr. DeCastro executed three
separate decision documents on behalf of the Thompsons agreeing
to the following deficiencies:
Year
Deficiency
Additions to Tax
1979
1980
1981
--$34,425
30,000
-------
The December 1986 settlements that Mr. McWade extended to
Mr. DeCastro's clients differed from the 7-percent official
Kersting project settlement offer used by respondent's Appeals
Office.
In particular, the Thompson settlement included the
burnout feature and was based on a reduction of the deficiencies
that respondent had determined against the Thompsons of
approximately 19 percent as follows:
Year
Adjustment
Deficiency
Settlement
% Reduction
1979
1980
$39,477
72,840
Total
$18,161
24,838
42,999
--$34,425
34,425
20%
36,295
79,294
30,000
64,425
17
19
1981
$80,782
All years total
The adjustments for each year consisted solely of the
disallowance of deductions that the Thompsons had claimed with
respect to Kersting programs.
- 94 On December 30, 1986, Mr. Thompson sent a letter to
Mr. McWade enclosing checks for $34,000 and $25,545 that were
intended as payments of interest on the Thompsons' tax
liabilities for the taxable years 1980 and 1981, respectively.44
2.
First Revision of Thompson Settlement
On January 27, 1987, Mr. Huestis sent a letter to
Mr. DeCastro stating that Mr. Thompson did not understand the
terms of his settlement.
On February 3, 1987, Mr. DeCastro
responded to Mr. Huestis as follows:
Dear Sam:
Thanks for your letter of January 27, 1987
indicating questions which Jack Thompson has regarding
the proposed settlement. I will respond in the order
of your questions:
1.
The only years in dispute are 1979, 1980 and
1981.
2. For each year, the amounts claimed due by the
I.R.S. by category are:
Tax deficiency
Penalty
Interest
1979
1980
1981
Total
$18,161
908
19,977
39,046
$24,838
1,242
24,838
50,918
$36,295
19,757
27,976
84,028
$79,294
21,907
72,791
173,992
3. By the terms of the proposed settlement, the
following amounts are due to be paid by Jack:
44
Many Kersting program participants, like the Thompsons,
made interest payments on or immediately before Dec. 31, 1986,
in order take advantage of the full deductibility of interest
in 1986. The deductibility of payments of personal interest was
subject to phase-out for taxable years beginning after Dec. 31,
1986, pursuant to TRA sec. 511(b), 100 Stat. 2246.
- 95 -
Tax deficiency
Interest
1979
1980
1981
Total
0
0
0
$34,425
35,275
69,700
$30,000
24,270
54,270
$64,425
59,545
123,970
As you can see, this amounts to a substantial
reduction in tax liabilities.
4. Jack correctly understands that his recent
payment of $59,545 was entirely applied to interest.
5. The IRS is willing to settle with Jack only on
the basis that his test case remains active. The terms
are not contingent upon any specific testimony or
degree of cooperation and will be filed upon completion
of the test case. Jack need only testify, at the trial
and is only technically a defendant. Unless some
dramatic changes in schedule occur, there will be no
depositions. Essentially, Jack need only testify, be
protected from Kersting, and does not need to prepare a
full-blown defense.
6. As indicated, the IRS insists upon Jack
continuing as a test case defendant for its own
purposes. That is presently a condition of the
settlement. In addition, we simply do not trust
Kersting to act in accordance with his promises and
staying in the case appears to be wise insurance to
obtain cancellation of the notes, etc.
7. I enclose a copy of a letter we have sent to
Kersting's attorney regarding the notes issue for your
information.
8. If we are unable to obtain a cancellation of
notes and recovery of funds invested for Jack through
negotiation, we will certainly look to retain John
Chanin or other local counsel for that purpose.
On February 6, 1987, Mr. Huestis reviewed Mr. DeCastro's letter
with Mr. Thompson and was satisfied that Mr. Thompson understood
the status of his case.
On March 13, 1987, following the Maui session, Mr. McWade
sent Mr. DeCastro a revised decision for docket No. 31236-84
reducing the Thompsons' tax deficiency for 1980 from $34,425 to
- 96 $33,000.
Mr. Sims reviewed and approved Mr. McWade's letter to
Mr. DeCastro.
Although the record contains no explanation for
this revision of the Thompson settlement, the revision
effectively increased the Thompson settlement from 19 percent to
approximately 20 percent.
On April 7, 1987, Mr. DeCastro sent
Mr. Thompson a letter informing him that the Internal Revenue
Service had reduced his tax liability for 1980 by approximately
$1,000.
Mr. DeCastro also informed Mr. Thompson that this
reduction would also save him approximately $1,000 in interest.
On June 4, 1987, the Court granted respondent's Motion to
Withdraw Stipulation of Settlement for Tax Shelter Adjustments in
the Thompson cases at docket Nos. 19321-83 and 31236-84.45
Mr. McWade filed the motions on the stated ground that, because
the Thompsons had been designated as test cases, it was
inappropriate for the Thompson piggyback agreements to remain in
effect.
Mr. McWade's motions stated that Mr. DeCastro did not
object to the granting of the motions.
Because Messrs. McWade
and DeCastro had previously agreed to settle the Thompson cases,
the above-referenced motion is the first instance in which the
Court was misled by the failure of counsel who were in the know
to disclose that the Thompson cases had been settled.
45
The Thompsons had not signed a piggyback agreement for
their case at docket No. 30965-85. The only other test case
petitioners who had signed piggyback agreements were the Dixons,
in their case at docket No. 9382-83, and Mr. Rina, in his case at
docket No. 17640-83. All the piggyback agreements signed by test
case petitioners had been signed in June 1985 and were in the
form of the 1985 agreement set forth supra pp. 44-45.
- 97 On June 15, 1987, Mr. DeCastro sent a $63,000 cashier's
check "in partial payment of the total amount due" to the
Internal Revenue Service Center in Fresno, California, on behalf
of the Thompsons.
The remittance was made with respect to the
Thompsons' three docketed cases and included a request that the
matter be referred to a problems resolution officer "so that we
can determine the balance due and conclude this matter."
On
June 17, 1987, the Commissioner "transferred" $775 of the $63,000
payment to the Thompsons' account for 1988 and applied the
$62,225 balance to the Thompsons' account for 1979.46
As of June
1987, the Thompsons had paid a total of $121,770 towards their
tax liabilities (tax and interest) for the taxable years 1979,
1980, and 1981.
On July 10, 1987, Mr. DeCastro wrote to Mr. McWade
transmitting a Notice of Overdue Tax received by the Thompsons
with respect to their 1981 income tax liability.
Mr. DeCastro
asked Mr. McWade to contact him regarding the notice and to send
him "copies of the decisions entered in this matter."
On
July 24, 1987, Mr. McWade sent Mr. DeCastro copies of proposed
decision documents for the Thompson cases.
Mr. McWade informed
Mr. DeCastro that "per our understanding, since the Thompsons are
46
The record does not reflect the basis for the
Commissioner's transfer of $775 of the payment to the Thompsons'
account for 1988. Because the 1988 tax year had not even started
on the date of the transfer, there can be no reasonable
explanation for the transfer; perhaps it was a typographical
error and was intended to refer to the taxable year 1978, which
Mr. Huestis had settled on the Thompsons' behalf.
- 98 involved as a test case, the documents are being held in our
files, and will be signed and filed with the Court when the test
case litigation has been completed."
The revised decision
documents prepared by Mr. McWade set forth the Thompsons' tax
liabilities as follows:
Year
Deficiency
Additions to Tax
1979
1980
1981
--$33,000
30,000
-------
On August 5, 1987, Mr. DeCastro sent copies of the proposed
decision documents to the Thompsons.
3.
Second Revision of Thompson Settlement
Before the trial of the test cases, Mr. DeCastro informed
Mr. McWade that the Thompsons were having financial difficulties
and that he did not think that it was fair to require the
Thompsons to remain as test case petitioners.
Mr. DeCastro
expressed concern to Mr. McWade about the amount of legal fees
the Thompsons would incur as test case petitioners and informed
Mr. McWade that he would attempt to have the Thompsons removed
from the list of test cases.
Mr. McWade told Mr. DeCastro that
he did not want the Thompsons to be removed as test case
petitioners because he did not want to change the test cases so
close to trial.
Mr. DeCastro thought that Mr. McWade's desire to
retain the Thompsons on the list of test cases was caused by
administrative or technical concerns.
Mr. DeCastro and Mr. McWade resolved their respective
concerns by further modifying the Thompson settlement.
In
- 99 particular, Mr. McWade agreed to reduce
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