UNITED STATES TAX COURT

Agency decision

Ask Donna

What actually matters in this document.

Text

T.C. Memo. 2008-124

UNITED STATES TAX COURT

LARRY L. HARTMAN, ET AL.,1 Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent*

Docket Nos.

1371-85,

4116-87,

16761-87,

29429-88.

48690-86,

15673-87,

18551-88,

Filed May 1, 2008.

Ps’ cases were part of the Kersting tax shelter

project, which the parties and the Tax Court tried to

resolve by using a test case procedure that resulted in

Dixon v. Commissioner, T.C. Memo. 1991-614 (Dixon II),

vacated and remanded sub nom. DuFresne v. Commissioner,

26 F.3d 105 (9th Cir. 1994), on remand Dixon v.

Cases of the following petitioners are consolidated

herewith: Wilbert L. F. and Valarie W. Liu, docket No. 48690-86;

and Jesse M. and Lura L. Lewis, docket Nos. 15673-87, 18551-88,

and 29429-88.

This opinion reconsiders and supersedes our previously

filed Memorandum Opinion Lewis v. Commissioner, T.C. Memo. 2005205.

- 2 Commissioner, T.C. Memo. 1999-101 (Dixon III),

supplemented by T.C. Memo. 2000-116 (Dixon IV), revd.

and remanded 316 F.3d 1041, 1047 (9th Cir. 2003) (Dixon

V), on remand T.C. Memo. 2006-90 (Dixon VI),

supplemented by T.C. Memo. 2006-190 (Dixon VIII) (on

appeal).

In Dixon V, the Court of Appeals for the Ninth

Circuit held that the misconduct of M (R’s trial

attorney) and S (M’s supervising attorney) in arranging

secret settlements with test case petitioners the Ts

and the Cs was a fraud on the Tax Court. The Court of

Appeals observed that the fraud not only violated the

rights of the other test case petitioners and

petitioners in more than 1,300 cases bound by the

outcome of the test cases but also defiled the sanctity

of the Court and the confidence of all future

litigants. The Court of Appeals ordered the Tax Court

to sanction R by entering judgments in favor of the

remaining test case petitioners and other petitioners

in the Kersting tax shelter group before the Court of

Appeals, on terms equivalent to those provided in the

Ts’ secret settlement agreement. The Court of Appeals

left the fashioning of such judgments to the discretion

of the Tax Court.

Shortly before the trial of the test cases that

resulted in the Tax Court’s opinion in Dixon II, P1

settled his cases on terms more favorable to him than

R’s project settlement offer but less favorable to him

than the Ts’ settlement, and stipulated decisions were

entered in P1’s cases.

After the trial, Dixon II opinion, and entry of

decisions in the test cases, R’s management discovered

the misconduct of M and S when M attempted to have R

assess deficiencies in the Ts’ and the Cs’ cases in

accordance with the secret settlements rather than with

the Court’s decisions in those cases. In motions to

vacate the decisions entered in the cases of the Ts,

the Cs, and a third test case petitioner, R disclosed

to the Court the misconduct of M and S. R concedes

that stipulated decisions in Kersting project nontest

cases entered after the Court filed its Dixon II

opinion and before R disclosed the misconduct of M and

S to the Court should be vacated.

- 3 While the remaining test cases were on appeal, R

reinstated R’s Kersting project settlement offer by

means of an offer letter that contained material

omissions. The offer letter stated: “Acceptance of

this settlement offer will preclude any further

challenge or appeal with respect to the Kersting

programs or the merits of the Dixon opinion. Any other

issues involved in this case will be resolved

separately.” P2s (proceeding pro sese at the time) and

P3s (represented by counsel) accepted R’s offer, and

stipulated decisions were entered in their cases.

Other Kersting project petitioners accepted the

reinstated project settlement offer; as a result,

stipulated decisions were entered in more than 400

cases.

The stipulated decisions entered in Ps’ cases were

not appealable and became final many years ago. Ps now

seek to have their decisions vacated so that the

sanctions mandated by the Court of Appeals in Dixon V

can be imposed on R in their cases. Ps argue that,

because they were bound by the decisions in the test

cases, the fraud committed by M and S in the test cases

necessarily adversely affected their cases. They ask

this Court to impose on R the same sanctions mandated

by the Court of Appeals in Dixon V for the fraud on the

Court of M and S in the test cases which, they assert,

is imputed to their cases.

In Lewis v. Commissioner, T.C. Memo. 2005-205, we

denied the motions of P3s for leave to file motions to

vacate their stipulated decisions on the grounds they

and their counsel had become aware of the misconduct of

R’s attorneys and of the pending appeals by test case

petitioners when they agreed to the decisions. P3s

filed a motion for reconsideration asking us to

reconsider our Lewis opinion on the ground that their

settlement agreements did not encompass or foreclose

imposing sanctions on R for the fraud M and S committed

on the Court. We granted the motion for

reconsideration, granted the motions for leave filed by

P1, P2s, and P3s, and consolidated the three sets of

cases for purposes of this opinion. Upon

reconsideration, we hold that the law of the case set

forth in Dixon V requires that Ps’ motions to vacate

stipulated decisions be granted and that all Kersting

project petitioners whose cases were bound by the test

- 4 cases and who suffered entry of stipulated decisions

are entitled to the benefit of the T settlement.

1. Held: The fraud on the Court committed by R’s

attorneys in the test case proceedings constituted

fraud on the Court in every case bound by the outcome

of the test cases and harmed the integrity of the

judicial process, not only as the test case procedure

was employed in the Kersting project cases, but also as

it might be employed in the future.

2. Held, further, imposing the sanctions against

R in every case that was part of the Kersting tax

shelter project is the appropriate sanction for the

fraud committed in the test case proceedings because it

serves to remedy the harm done to the judicial process,

restore public confidence in the test case procedure,

and rectify the violation of the rights of every

petitioner bound by the outcome of the test cases.

3. Held, further, once R discovered the

misconduct of R’s attorneys, R had an obligation to

fully disclose the misconduct, not only to the Court

and the test case petitioners, but also to all

petitioners who had been bound by the outcome of the

Kersting project test cases.

4. Held, further, R’s posttrial settlement offer

did not adequately disclose R’s attorneys’ misconduct

to the offerees and did not remedy or purge the fraud

from the Kersting project cases.

5. Held, further, P2s’ and P3s’ requests that

sanctions be imposed on R for the fraud committed on

the Court are not a “challenge or appeal with respect

to the Kersting programs or the merits of the Dixon

opinion” encompassed by R’s posttrial settlement offer,

but rather encompass another issue in their cases that

is to “be resolved separately” under the specific terms

of that offer.

6. Held, further, the posttrial and other

settlements and stipulated decisions entered in the

cases at hand and in other Kersting project cases do

not divest the Tax Court of its inherent power to

impose sanctions against R for the fraud committed on

the Court in those cases. See, e.g., Bader v. Itel

Corp. (In re Itel Secs. Litig.), 791 F.2d 672 (9th Cir.

- 5 1986) (party cannot avoid sanctions for committing

fraud on the court by settlement or withdrawing from

the case).

7. Held, further, the Tax Court has inherent

power to impose sanctions against R for the fraud

committed on the Court in every case that was part of

the Kersting tax shelter project and may impose such

sanctions either by vacating the decision in each such

case and entering a new decision or by separate order

imposing an equivalent monetary sanction. In the cases

at hand, we are vacating the decisions.

8. Held, further, once the new decisions in these

cases become final, the Court will issue an

implementation order to allow R reasonable time to

notify all remaining Kersting project petitioners

against whom stipulated decisions were entered and to

adjust their accounts administratively in accordance

with the terms of the Ts’ settlement. The Court will

not accept for filing motions for leave to file motions

to vacate the decisions in the cases of other such

Kersting project petitioners unless R fails to adjust

their accounts administratively within 9 months after

the date of entry of the implementation order.

Robert Alan Jones and Declan J. O’Donnell, for petitioner

Larry L. Hartman in docket Nos. 1371-85, 4116-87, and 16761-87

and for petitioners Jesse M. and Lura L. Lewis in docket Nos.

15673-87, 18551-88, and 29429-88.

Matthew K. Chung, for petitioners Wilbert L. F. and Valarie

W. Liu in docket No. 48690-86.

Henry E. O’Neill, for respondent.

- 6 CONTENTS

Page

Introduction

Background

. . . . . . . . . . . . . . . . . . . . . . . . . 8

. . . . . . . . . . . . . . . . . . . . . . . . .

The Kersting Project Test Case Proceedings

. . . .

II.

Respondent’s Discovery and Disclosure of the

Thompson and Cravens Settlements . . . . . . . . .

III. Kersting’s Responses to Dixon II and Discovery and

Disclosure of the Secret Settlements: Letters to

Kersting Program Participants and Formation of the

Kersting Defense Group . . . . . . . . . . . . . .

IV.

Respondent’s Posttrial Settlement Offer

. . . . .

The Lewis and Liu Settlements . . . . . . . . . . .

VI.

Disciplinary Actions Against McWade and Sims

. . .

VII. Appeals to the Court of Appeals for the Ninth

Circuit and Proceedings on Remand . . . . . . . . .

Ninth Circuit Remand: DuFresne v.

Commissioner and Adair v. Commissioner . . . .

Evidentiary Hearing and Opinions on DuFresne

Remand: Dixon III and IV . . . . . . . . . .

Gridley v. Commissioner

. . . . . . . . . . .

Dixon V: Court of Appeals Again Reverses and

Remands . . . . . . . . . . . . . . . . . . .

Responses to Dixon V by the Office of Chief

Counsel . . . . . . . . . . . . . . . . . . .

Determination on Remand of Terms of the

Thompson Settlement by Dixon VI and VIII

. .

. . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . .

VIII.

Discussion

Motions To Vacate

- 7 I.

Preliminary Comments

II.

Analysis

. . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . .

The Fraud on the Court Committed by

Respondent’s Attorneys, the Harm Done

Thereby, and the Sanction Mandated by the

Court of Appeals . . . . . . . . . . . . . . .

Lewis v. Commissioner Reconsidered and

Superseded . . . . . . . . . . . . . . . . . .

Subsequent Voluntary Disclosure of the Fraud

on the Court Does Not Purge the Fraud . . . .

Respondent’s Posttrial Settlement Offer Did

Not Satisfy Respondent’s Obligations to the

Nontest Case Petitioners . . . . . . . . . . . 101

Respondent’s Posttrial Settlement Offer Did

Not Rectify the Harm and Does Not Preclude

Additional Sanctions . . . . . . . . . . . . . 110

Conclusion

. . . . . . . . . . . . . . . . . . . . . . . . . 127

Implementation of Sanction

. . . . . . . . . . . . . . . . . 130

APPENDIX A

. . . . . . . . . . . . . . . . . . . . . . . . . 134

APPENDIX B

. . . . . . . . . . . . . . . . . . . . . . . . . 136

- 8 MEMORANDUM OPINION

BEGHE, Judge:

These consolidated cases are before the Court

on petitioners’ motions under Rule 1622 to vacate stipulated

decisions entered many years ago.

Petitioners’ cases are broadly

representative of hundreds of cases in which stipulated decisions

were entered and of dozens of such cases in which motions for

leave to file motions to vacate stipulated decisions have been

filed.

Introduction

Petitioners’ motions arise from the misconduct of

respondent’s attorneys in implementing the Court’s test case

procedure used by the Court in the Kersting tax shelter project

to try and decide Dixon v. Commissioner, T.C. Memo. 1991-614

(Dixon II), vacated and remanded sub nom. DuFresne v.

Commissioner, 26 F.3d 105 (9th Cir. 1994), on remand Dixon v.

Commissioner, T.C. Memo. 1999-101 (Dixon III), supplemented by

T.C. Memo. 2000-116 (Dixon IV), revd. and remanded 316 F.3d 1041

(9th Cir. 2003) (Dixon V), culminating with our disposition of

the second remand in Dixon v. Commissioner, T.C. Memo. 2006-90

(Dixon VI), supplemented by T.C. Memo. 2006-190 (Dixon VIII).3

Unless otherwise indicated, all Rule references are to the

Tax Court Rules of Practice and Procedure, and all section

references are to the Internal Revenue Code.

In Dixon v. Commissioner, T.C. Memo. 2006-97 (Dixon VII)

and Young v. Commissioner, T.C. Memo. 2006-189, we responded to

(continued...)

- 9 have entered decisions in the 27 docketed cases that participated

in the second remand; 13 of those cases are on appeal to the

Court of Appeals for the Ninth Circuit,4 where, we assume, they

will be considered by the panel that decided Dixon V.5

In Dixon V, the Court of Appeals held that the misconduct of

respondent’s trial attorney and his supervisor was a fraud on the

Court that violated the rights of all Kersting project

petitioners who had agreed to be bound by the outcome of the Tax

Court proceeding.

The Court of Appeals ordered this Court to

sanction respondent by entering decisions in the cases of the

remaining test case petitioners and other Kersting project

(...continued)

the supplemental mandate of the Court of Appeals for the Ninth

Circuit in Dixon v. Commissioner, 316 F.3d 1041 (9th Cir. 2003)

(Dixon V), revg. T.C. Memo. 1999-101 (Dixon III), to determine

the appellate legal fees to which Kersting project petitioners

and their counsel in Dixon V were entitled. We have currently

under consideration motions by various Kersting project taxpayers

and their counsel for awards of fees and expenses for services

rendered in the Dixon V remand proceedings in this Court.

On July 6, 2007, Kersting project petitioners filed a

notice of appeal in Hongsermeier v. Commissioner, docket No.

29643-86, a test case. On Sept. 10, 2007, Kersting project

petitioners filed notices of appeal in Rogers v. Commissioner,

docket No. 17993-95, Huber v. Commissioner, docket No. 20119-84

and Titcomb v. Commissioner, docket No. 17992-95, all nontest

cases. On Sept. 17, 2007, Kersting project petitioners filed

notices of appeal in test cases Young v. Commissioner, docket

Nos. 4201-84, 22783-85, and 30010-85, and Owens v. Commissioner,

docket No. 40159-84, and in nontest cases Adair v. Commissioner,

docket Nos. 17642-83, 38965-84, 35608-86, 479-89, and 8070-90.

The separate mandate of the Dixon V panel on appellate

legal fees concluded: “The panel retains jurisdiction over all

further proceedings that may arise.”

- 10 petitioners before the Court of Appeals on terms equivalent to

those provided in the secret Thompson settlement.

Petitioners signed stipulations to be bound (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.6

Before the test cases were tried, respondent’s trial

attorney and his supervisor had entered into secret settlements

with test case petitioners John R. and Maydee Thompson (the

Thompsons) and John R. and E. Maria Cravens (the Cravenses).

Also, before the test cases were tried, petitioner Larry L.

Hartman (Hartman) settled his cases with respondent, and

stipulated decisions were entered in his cases in January 1989.

After the Court had issued its opinion in Dixon II and

entered decisions in the test cases, respondent’s management

Although no piggyback agreement signed by petitioner Larry

L. Hartman (Hartman) was filed in docket No. 16761-87, that case

was not set to be tried with the test cases, and he was

effectively bound by the results in the test cases in docket No.

16761-87, as well as in docket Nos. 1371-85 and 4116-87, in which

he had signed piggyback agreements that were filed with the

Court. Normally, petitioners 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 final decisions in the test cases, will be ordered to

show cause why their case should not be decided the same way as

the test cases. See, e.g., Lombardo v. Commissioner, 99 T.C.

342, 343 (1992), affd. on other grounds sub nom. Davies v.

Commissioner, 68 F.3d 1129 (9th Cir. 1995); Dixon VII; Dixon v.

Commissioner, T.C. Memo. 2000-116 (Dixon IV). In Dixon v.

Commissioner, T.C. Memo. 2006-90 (Dixon VI), we held that

Kersting project petitioners who did not sign piggyback

agreements were entitled to the same relief as those who had

signed piggyback agreements. Dixon VI, 91 T.C.M. (CCH) 1086 at

1107, 2006 T.C.M. (RIA) par. 2006-090 at 2006-671.

- 11 discovered the secret settlements and disclosed them to the

Court.

Following that disclosure, respondent reinstated

respondent’s project settlement offer, which respondent had

previously terminated before the trial that resulted in the

Court’s opinion in Dixon II.

Petitioners Jesse M. and Lura L.

Lewis (the Lewises), through their counsel, and petitioners

Wilbert L. F. and Valarie W. Liu (the Lius), proceeding pro sese,

accepted respondent’s posttrial settlement offer, and stipulated

decisions were entered in their cases in March and June 1993,

respectively.

The decisions in all of petitioners’ cases herein

were entered, and their cases were closed, before the Court of

Appeals for the Ninth Circuit issued its opinion in DuFresne v.

Commissioner, supra, vacating and remanding Dixon II for an

evidentiary hearing to determine the full extent of respondent’s

misconduct and its effect on the decisions in the remaining test

cases under Dixon II, which we did in our opinions in Dixon III

and IV.

After the opinion of the Court of Appeals in Dixon V,

reversing and remanding Dixon III and IV for entry of decisions

in the remaining test cases in accordance with Dixon V,

petitioners herein at various times in 2004 filed motions for

leave to vacate the stipulated decisions entered by this Court in

their cases.

- 12 Petitioners assert that the fraud on the Court perpetrated

by respondent’s trial attorney and his supervisor in the test

cases was a fraud on the Court in their cases because they were

bound by the outcome of the test case proceedings.

Petitioners

ask the Court to vacate the decisions in their cases so that the

Court can impose on respondent in their cases the same sanctions

mandated by the Court of Appeals in Dixon V for

the fraud on the Court in the test cases as they apply to more

than 1,300 pending cases in the Kersting project that did not

settle.7

In Lewis v. Commissioner, T.C. Memo. 2005-205, we denied the

Lewises’ motions for leave to file motions to vacate their

stipulated decisions on the grounds that they and their counsel

had become aware of the misconduct of respondent’s attorneys and

of the pending appeals by test case petitioners when they

stipulated the decisions.

The Lewises filed motions for reconsideration, which we

granted.

We also granted the motions for leave in the Lewis,

Hartman, and Liu cases8 in order to consolidate them for purposes

As of Mar. 13, 2008, 1,173 Kersting project cases remained

on the Court’s inventory of docketed cases in which decisions

have never been entered. The number of cases referred to in the

text has been reduced by decisions that have been entered after

and in accordance with our opinions in Dixon VI and VIII on the

terms of the Thompson settlement. See infra note 33.

In so doing, we departed from our usual practice--which we

had followed in our Lewis opinion--of considering the merits of

(continued...)

- 13 of this opinion because they are all appealable to the Court of

Appeals for the Ninth Circuit.

We also chose to consolidate

these cases because they include cases where stipulated decisions

were entered both before the Court filed its Dixon II opinion

(the Hartman decisions) and after respondent discovered

respondent’s attorneys’ misconduct and disclosed it to the Court

and reinstated the 7-percent project settlement offer (the Lewis

and Liu decisions).

For purposes of these motions, we take judicial notice of

our findings in Dixon III and IV, as modified by Dixon V, VI, and

VIII (the Dixon findings) and supplemented by Lewis v.

Commissioner, supra.

Additional facts concerning earlier drafts

of respondent’s posttrial settlement offer are from copies of the

drafts of the proposed settlement offer admitted into the records

in these cases as the Court’s exhibits.

Otherwise, additional

pertinent facts, as set forth in petitioners’ motions,

respondent’s oppositions thereto, and the parties’ replies to

(...continued)

the underlying (lodged) motion to vacate decision in order to

determine whether the moving party had alleged sufficient facts

to call into question the validity of the decision. See

Brannon’s of Shawnee, Inc. v. Commissioner, 69 T.C. 999, 1002

(1978); see also Kenner v. Commissioner, 387 F.2d 689, 690-691

(7th Cir. 1968); Toscano v. Commissioner, 52 T.C. 295, 296

(1969), vacated on another issue 441 F.2d 930 (9th Cir. 1971);

Campbell v. Commissioner, T.C. Memo. 1988-103. In the cases at

hand, we granted petitioners’ motions for leave in orders filed

in June 2006 (Lius and Lewises) and October 2006 (Hartman),

leaving for further proceedings our determination in this opinion

whether the decisions can and should be vacated.

- 14 orders of the Court raising questions addressed to the parties,

are undisputed.9

We believe that all the pending motions may be decided

without a hearing.10

On reflection and reconsideration, we now

decide that the motions to vacate filed by the Lewises should be

granted; we also hold that the motions to vacate filed by Hartman

and the Lius should be granted.

We conclude this opinion by

describing the procedure for implementing our determination that

all Kersting project petitioners against whom stipulated

decisions were entered on or after June 10, 1985, are entitled to

the benefits of the Thompson settlement.

Giving effect to these

decisions and that procedure will result in imposing on

respondent in all Kersting project cases the sanctions mandated

by the Court of Appeals in Dixon V.

Background

When the petitions in these cases were filed, Hartman

resided in Everett, Washington, the Lewises resided in Westlake

Village, California, and the Lius resided in Aiea, Hawaii.

Decisions in these consolidated cases are appealable to the

Court of Appeals for the Ninth Circuit. Motions similar to those

under consideration herein have been filed and lodged by other

taxpayers whose decisions are appealable to Courts of Appeals for

other circuits.

Respondent agrees that the Court has before it the records

that produced the Dixon findings and “strenuously opposes” the

scheduling of an evidentiary hearing.

- 15 I.

The Kersting Project Test Case Proceedings

In response to the large volume of cases generated by tax

shelter examinations during the late 1970s and early 1980s, the

Internal Revenue Service (IRS) and the Tax Court developed

procedures that 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 IRS, Office

of Chief Counsel, in Washington, D.C. (the National Office),

created the Tax Shelter Branch in the National Office to oversee

tax shelter litigation across the country and to organize and

supervise individual tax shelter projects.

One of the goals of the Tax Shelter Branch 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’s office and the District

Counsel’s offices to which the project was assigned.

The deficiencies, additions to tax, and interest at issue in

the Dixon II test case proceedings arose from petitioners’

participation in tax shelter programs promoted by Henry F.K.

Kersting (Kersting) that purported to generate interest

- 16 deductions for income tax purposes that exceeded amounts paid to

participate in the programs.

Kersting’s promotions of his tax

shelter programs attracted the attention of the IRS, which

instituted a tax shelter project known as the Kersting project.

Kersting actively opposed respondent’s enforcement activities

against his programs.

In early 1982 Attorney Brian J. Seery

(Seery) began assisting Kersting program participants with issues

arising from audits of their income tax returns.

On March 1,

1985, Kersting sent letters informing Kersting program

participants that he had retained Seery to represent them in the

Tax Court at no charge to them.

Ultimately, more than 1,800

cases arising from taxpayers’ petitions against respondent’s

deficiency notices disallowing deductions claimed by participants

in the Kersting programs were filed in the Tax Court.

The bulk

of those deficiency notices were facilitated by respondent’s

having obtained Kersting’s client records in a search of his

office in Honolulu, Hawaii, in January 1981.

The IRS established the Kersting project in its Honolulu

Appeals Office.

In any given tax shelter project, a project

Appeals officer typically works with a project attorney in the

District Counsel’s office.

In the Kersting project, Kenneth W.

McWade (McWade), in the Honolulu District Counsel’s office, was

the project attorney.

- 17 On March 20, 1985, Seery entered his appearance for hundreds

of Kersting project taxpayers.

The Court set for trial the cases

of approximately 375 Kersting program participants to be held

before Judge William A. Goffe (Judge Goffe) at a Tax Court

session scheduled to commence on June 10, 1985, in Honolulu,

Hawaii (the June 1985 session).

It would have been a daunting task to try the cases of the

hundreds of similarly situated Kersting program participants who

had filed petitions in the Tax Court.

Before the June 1985

session, McWade and Seery agreed to use the test case procedure

whereby a few typical cases are selected and most taxpayers whose

cases are not selected execute “piggyback agreements” binding the

resolution of their cases to the outcome of the final decisions

in the test cases.

During the June 1985 session, McWade and

Seery discussed the use of the test case procedure with Judge

Goffe during a chambers conference.

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, as

early as June 1985, Kersting project petitioners began filing

piggyback agreements, which they did in most of the Kersting

project cases.

On November 21, 1985, the Chief Judge of this Court assigned

all the Kersting project cases to Judge Goffe for trial or other

- 18 disposition.

Subsequent Kersting project cases were

automatically assigned to Judge Goffe.

By letter dated June 10, 1986, McWade notified Judge Goffe

that he and Seery had selected the cases of one individual, Ralph

J. Rina (Rina), and seven couples, including the Thompsons, the

Cravenses, and Jerry and Patricia A. Dixon (the Dixons), to be

test cases.

By letter dated July 30, 1986, Judge Goffe informed

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 Seery and McWade that he intended to notify

each Kersting project petitioner who had not filed a piggyback

agreement that his or her case would be set for trial during the

Maui session.

By letter dated August 5, 1986, Judge Goffe informed all

Kersting project 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 stated 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.

- 19 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

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

project petitioners who had not filed piggyback agreements that

their cases were set for trial at the Maui session.

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.

- 20 An attorney hired by the Thompsons to prepare an estate plan

for them raised questions with Seery about his association with

Kersting.

On October 31, 1986, Seery filed a motion to withdraw

as counsel for the Thompsons in their docketed cases, which the

Court granted.

In November 1986 the Thompsons engaged Luis

DeCastro (DeCastro) to represent them before this Court.

In December 1986, following similar questions by the Court,

Seery withdrew as counsel for the other test case petitioners and

all the Kersting project nontest case petitioners for whom he had

filed notices of appearance.

In early January 1987, Kersting

engaged Attorneys Robert J. Chicoine (Chicoine) and Darrell D.

Hallett (Hallett) to represent the test case petitioners (with

the understanding they would not represent Kersting).

Chicoine

and Hallett filed entries of appearance as counsel in each of the

test cases (other than the Thompson and Cravens cases) and

promptly challenged the deficiency notices in the test cases on

the ground that the IRS search of Kersting’s office in January

1981 had been illegal.

Between 1982 and 1988 respondent had in effect an official

settlement offer for the Kersting project.

In general, the

project settlement offer permitted participants in the Kersting

programs to resolve their cases by agreeing to pay deficiencies

that averaged 7 percent less than those determined in their

deficiency notices.

The project settlement offer also released

- 21 participants from negligence additions and increased interest.

Respondent’s purpose in offering these concessions and

adjustments was to provide similar treatment for all Kersting

program participants who wished to settle their cases.

Respondent’s 7-percent reduction project settlement offer in

the Kersting project was similar to the IRS project settlement

offer in other tax shelter projects.

The 7-percent reduction in

the deficiencies reflected allowance of an assumed deduction for

the taxpayers’ out-of-pocket expenses of participating in the

shelter.11

Although District Counsel generally is expected to adhere to

the terms of an official project settlement offer, once a tax

shelter project is assigned to a particular District Counsel’s

office, that office has the authority to settle any individual

case in the project.

District Counsel has the authority in

special circumstances to settle individual tax shelter project

cases on a basis different from the project settlement offer.

By September 1986 McWade and Seery had agreed to modify the

7-percent reduction project settlement offer to incorporate a new

feature, called the burnout, that would apply in cases involving

The 7-percent reduction in the deficiencies amounted to a

“nuisance value” settlement that respondent would not have

entertained or offered in a run-of-the-mill case. See IRM sec.

8.6.1.3.3 (Feb. 18, 1999). Nuisance value is any concession that

is made solely to eliminate the inconvenience or cost of further

negotiations or litigation and is unrelated to the merits of the

issues.

- 22 more than 1 taxable year.

Under the burnout, the interest on a

taxpayer’s total unpaid Kersting-related deficiencies for the

first and second years of tax liability would not begin to accrue

until the return due date for the second year.

This was

accomplished by zeroing out the taxpayer’s agreed deficiency for

the first year and adding it to the agreed deficiency for the

second year.

The burnout thus postponed for a year the accrual

of interest on the first year’s deficiency, thereby reducing the

total interest accrued on the taxpayer’s Kersting-related

deficiencies.

In December 1986 McWade, with the knowledge and connivance

of his supervisor, Honolulu District Counsel William A. Sims

(Sims), entered into secret contingent settlement agreements with

the Cravenses regarding their test cases and with DeCastro

regarding the Thompsons’ test cases.

The Thompsons and the

Cravenses understood that a condition of these settlements was

that they would remain test case petitioners.

The Cravenses, who were not represented by counsel, agreed

with McWade to a reduction of about 6 percent of the originally

determined deficiencies for their taxable years 1979 and 1980.12

In the Cravens notices of deficiency, respondent had

determined that the Cravenses were liable for deficiencies for

1979 and 1980 of $4,508 and $19,251.70, respectively, and

additions to tax for negligence under sec. 6653(a) for both

years. The deficiencies and negligence additions so determined

were attributable to the Cravenses’ participation in Kersting tax

shelter programs. The Cravenses’ correct tax liabilities for

(continued...)

- 23 This settlement was less favorable to them than the generally

available modified 7-percent reduction settlement offer and did

not include the burnout.

The initial Thompson settlement in December 1986 reduced the

Thompsons’ total deficiencies by 18.8 percent,13 eliminated the

additions to tax for all years, and eliminated the increased

interest rate under section 6621(d)14 for 1981.

The initial

Thompson settlement also incorporated the burnout, combining the

agreed deficiencies for the years 1979 and 1980 in the year 1980

so as to postpone for 1 year the accrual of interest on the

agreed 1979 deficiency.

On December 23, 1986, McWade sent

(...continued)

1979 and 1980 were $4,508 and $5,893.45, respectively, for a

total of $10,401.45. The $5,893.45 figure for 1980 represents

the Cravenses’ correct tax liability after eliminating the

dividend adjustment set forth in the notice of deficiency for

1980 and backing out the tax on the capital gain that the

Cravenses had reported on their 1980 tax return. Decisions

entered in the Cravens cases provided that the Cravenses were

liable for deficiencies of $3,606.40 for 1979 and $6,175.76 for

1980, totaling $9,782.16.

In the Thompson notice of deficiency, respondent had

determined that the Thompsons were liable for deficiencies

totaling $79,293 for the taxable years 1979-81, for additions to

tax for negligence for 1979 and 1981, for increased interest for

1981 pursuant to sec. 6621(d), and for a late filing addition to

tax for 1981 under sec. 6651(a). The deficiencies, negligence

additions, and increased interest were attributable to the

Thompsons’ participation in Kersting tax shelter programs.

Sec. 6621(d) was redesignated sec. 6621(c) by the Tax

Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 1511(c)(1), 100

Stat. 2744, and repealed by the Omnibus Budget Reconciliation Act

of 1989, Pub. L. 101-239, sec. 7721(b), 103 Stat. 2399. We will

hereinafter refer to the provision as sec. 6621(c).

- 24 DeCastro decision documents incorporating the above-described

settlement.

McWade’s transmittal letter stated that the decision

documents in the Thompsons’ cases would not be filed with the

Court until the decisions in the test cases had become final.

Around yearend 1986 the Thompsons paid $59,545 as interest

on their then-agreed deficiencies.

In March 1987 respondent and

DeCastro agreed to a revision of the initial settlement that

effectively increased the reduction in the Thompsons’

deficiencies to approximately 20 percent.

On June 15, 1987, the

Thompsons halted further accrual of interest on the deficiencies

by paying the then total amount owed of $63,000.

By June 1987

payments by the Thompsons to the IRS with respect to the taxable

years 1979-81 (less a $770 offset credited to another year)

totaled $121,770.

Between September and December 1986 McWade and Sims began to

entertain 20-percent settlements based on the same general

approach as the modified 7-percent settlement offer that included

the burnout.

In late 1986 DeCastro obtained 20-percent reduction

settlements on behalf of other Kersting project nontest case

petitioners he represented, as did Chicoine and Hallett on behalf

of other nontest case petitioners in the course of efforts to

negotiate a global project settlement.

The enhanced 20-percent settlements reflected the concerns

of McWade and Sims that Chicoine’s and Hallett’s challenge of the

- 25 IRS search of Kersting’s office increased respondent’s risks of

litigation.

The availability of the 20-percent settlements was

not disseminated in writing by either Sims or McWade.

The

availability of 20-percent settlements became known, if at all,

through a combination of Kersting’s letters to program

participants and telephone inquiries to McWade from Kersting

program participants or their counsel.

In January 1987 Sims and Chicoine continued their efforts to

negotiate a global settlement of the Kersting project cases.

Initially, they tried to link a higher percentage settlement to

Kersting’s agreement to quit the tax shelter business.

They

eventually abandoned their efforts to link a global settlement to

Kersting’s future conduct.

By letter dated January 16, 1987, Chicoine notified Kersting

that he believed he had an agreement with Sims to settle all the

Kersting cases docketed in the Tax Court by allowing 50 percent

of the claimed interest deductions.

In that letter, Chicoine

further stated that he 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, Kersting wrote to program participants

that a 50-percent settlement had been negotiated and recommended

that they accept it.

As a result of Kersting’s letter,

- 26 approximately 300 Kersting program participants contacted

Chicoine and Hallett seeking representation.

Following the release of Kersting’s January 19, 1987,

letter, Sims received numerous telephone calls from Kersting

program participants and attorneys seeking to accept the

50-percent settlement.

By letter to Chicoine dated February 4,

1987, Sims denied that he had agreed to a 50-percent settlement.

During spring 1987 Chicoine continued to discuss a global

settlement with McWade.

On or about April 27, 1987, Chicoine

told Kersting he would recommend a 20-percent settlement to

Kersting program participants.

Between May 1987 and February

1988 Kersting wrote at least seven letters to Chicoine and

Hallett strongly objecting to their dissemination of a 20-percent

settlement proposal to Kersting program participants.

On January

12, 1988, 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”.

On February 8, 1988, Kersting wrote to Kersting program

participants warning them that Chicoine and Hallett soon would

circulate the details of a 20-percent settlement.

Kersting urged

Kersting program participants not to hire Chicoine and Hallett to

settle their cases and instead to await the Court’s opinion on

the legality of the search (the issue that had been raised and

- 27 presented by Chicoine and Hallett).

During this period, Kersting

threatened to sue Chicoine and Hallett if they reported the 20percent settlement offer to the Kersting program participants.

On February 9, 1988, Chicoine sent letters to Kersting

program participants who had contacted Chicoine and Hallett

about representation.

Chicoine reported that McWade had offered

to settle docketed Tax Court cases in accordance with the

20-percent settlement offer, recommended that program

participants seriously consider that settlement, and suggested

that those who desired to settle on those terms contact Chicoine

and Hallett.

On February 11, 1988, the Court filed Dixon v. Commissioner,

90 T.C. 237 (1988) (Dixon I), holding that the test case

petitioners had failed to establish standing to contest the IRS

search of Kersting’s office.

Kersting was displeased by Chicoine’s and Hallett’s

proposed overall disposition of the Kersting project cases with

only a 20-percent reduction in the deficiencies.

He fired

Chicoine and Hallett and engaged Attorney Joe Alfred Izen, Jr.

(Izen), to represent the test case petitioners at trial.

In April 1988 Chicoine and Hallett informed their test case

petitioner clients that they were withdrawing as their counsel

because of a disagreement with Kersting.

Chicoine and Hallett,

however, continued to negotiate settlements for nontest case

- 28 petitioners, including Hartman.

By letter dated June 9, 1988,

Chicoine and Hallett informed McWade that Hartman wished to

accept the 20-percent settlement with the burnout.

McWade sent

Chicoine stipulated decisions for Hartman’s cases.

Chicoine

executed the decision documents on Hartman’s behalf and returned

them to McWade on November 30, 1988.

decisions on December 12, 1988.

McWade executed the

On January 13, 1989, the Court

entered the stipulated decisions in Hartman’s cases at docket

Nos. 1371-85, 4116-87, and 16761-87.

In the meantime, DeCastro told McWade the Thompsons were

concerned about the legal fees they would incur as test case

petitioners.

DeCastro told McWade that it was unfair to require

the Thompsons to remain test case petitioners and that he would

attempt to remove the Thompsons’ cases from the list of test

cases.

McWade wanted to keep the Thompsons as test case

petitioners.

DeCastro and McWade resolved their differences by

further modifying the Thompson settlement.

In particular, McWade

agreed to reduce the Thompsons’ deficiencies by an additional

amount that would compensate them for the cost of having an

attorney represent them at the trial of the test cases.

Shortly before trial of the test cases in this Court, McWade

and DeCastro reached an oral agreement (the final Thompson

agreement) in the Thompsons’ cases calling for reduction of the

agreed deficiencies for 1979, 1980, and 1981 to zero, $15,000,

- 29 and $15,000, respectively.

The purpose of the final Thompson

agreement was to generate a refund, estimated to exceed $60,000,

that was to be used--and the bulk of which was used--to pay

DeCastro’s fees for providing the appearance of independent

representation of the Thompsons at the trial of the test cases.

Although McWade knew that IRS policy required him to treat

similarly situated taxpayers alike, the financial terms of

McWade’s final settlement with DeCastro for the Thompsons were

much more advantageous to them than McWade’s settlements with

other Kersting project petitioners.15

After the trial of the test cases, John R. Thompson

(Thompson) expressed concern to DeCastro about incurring

DeCastro’s additional fees.

DeCastro assured Thompson that

DeCastro was looking solely to the IRS for payment of his fees

and that the Thompsons would not be liable for any additional

fees.

On August 3, 1989, DeCastro wrote a letter to McWade,

reducing the final Thompson agreement to writing.

McWade signed

the letter and returned it to DeCastro.

Sims, McWade, and DeCastro did not inform the Court, the

National Office, the Regional Office, or counsel for the other

test case petitioners or any of the other Kersting project

petitioners or their counsel of the Thompson settlement or the

With the exception of Denis Alexander, a nontest case

petitioner with whom McWade made a special deal. See infra p.

30.

- 30 Cravens settlement.

McWade’s deception continued with a coverup,

which was carefully designed to prevent the Court and other

Kersting participants from learning of the secret settlement

agreements.

At Kersting’s deposition, which McWade attended,

Kersting’s lawyer objected to the presence of the Thompsons’

attorney because of rumors that the Thompsons were attempting to

settle.

Although McWade knew that the Thompsons had, in fact,

already settled, he remained silent.

McWade then misled the

Court by failing to disclose the settlement on April 22, 1988,

when he moved to set aside the Thompson piggyback agreements, a

necessary pretrial motion that confirmed the inclusion of the

Thompson cases among the test cases.

Before the trial of the test cases, McWade arrived at a

general understanding with nontest case petitioner Denis

Alexander (Alexander) that the Alexanders’ tax liabilities for

the taxable years 1974-77 would be reduced in exchange for

Alexander’s testimony and agreement to serve as an undisclosed

consultant or assistant to McWade during the trial of the test

cases.

McWade’s understanding with Alexander is reflected in

decision documents, executed by McWade on April 6, 1989, and

approved by Sims, that completely eliminated all Kersting and

other deficiencies determined against the Alexanders for those

years.

- 31 On January 10, 1989, the test cases were consolidated for

trial and opinion.

The trial of the test cases was conducted

from January 9 to 27, 1989, at Honolulu, Hawaii, with DeCastro

representing the Thompsons and Izen representing all the other

test case petitioners except the Cravenses, who were pro sese.

McWade’s deceptive silence matured into overt misconduct during

the trial of the test cases; when Thompson began to testify about

having settled his cases, McWade quickly interjected questions

about unrelated matters.

The diversion was successful; the Court

mistakenly interpreted Thompson’s remark as referring to

resolution of the Thompsons’ tax liability for another year that

was not at issue.

McWade also allowed Alexander to offer

misleading testimony that prevented the Court from learning that

McWade had agreed to zero out the Alexanders’ tax liabilities.

On December 11, 1991, the Court issued its opinion in Dixon

II, sustaining almost all of respondent’s determinations that the

Kersting programs in issue were ineffective for tax purposes.

In March 1992 the Court entered decisions in all the test

cases in accordance with its opinion in favor of respondent.

Consequently, the decisions initially entered in the Thompson and

Cravens cases were not in accordance with their secret settlement

agreements.

Izen appealed the decisions against the test case

- 32 petitioners (with the exception of the Thompsons, the Cravenses,

and Rina) to the Court of Appeals for the Ninth Circuit.

II.

Respondent’s Discovery and Disclosure of the Thompson and

Cravens Settlements

On May 8, 1992, after this Court had entered decisions in

favor of respondent in all the test cases, McWade and Sims, by

memorandum, requested the San Francisco Appeals Office to process

the Thompsons’ account administratively in accordance with the

Thompson settlement, not the Tax Court’s decisions.

On May 22,

1992, Danny Cantalupo, Regional Director of Appeals for the

Western Region, informed Peter D. Bakutes (Bakutes), Deputy

Regional Counsel for Tax Litigation for the Western Region in San

Francisco, of McWade’s and Sims’s request to process the Thompson

settlement.

Bakutes informed Benjamin Sanchez (Sanchez), Western

Regional Counsel in San Francisco, who informed officials in the

National Office.

The circumstances of the Thompson settlement

caused widespread concern within the IRS.

On May 29, 1992, Sims, at the direction of Sanchez, informed

DeCastro by letter that the Thompson settlement would not be

honored, and that assessments would be made in accordance with

the decisions entered on March 13, 1992, pursuant to Dixon II.

The letter advised that assessment of the taxes owing, plus

statutory additions and interest, would be “approximately

$302,396.12”.

The letter further noted:

“Of course, your

- 33 clients’ advance payments will be credited toward the

assessments.”

DeCastro had several telephone conversations with

respondent’s officials, in which he maintained that the Thompson

settlement, as memorialized in the August 3, 1989, letter

agreement, was an enforceable contract, and that he would appeal

any decision to the contrary.

Soon after Sanchez and Bakutes discovered the Thompson

settlement, McWade and Sims disclosed the Cravens settlement to

them.

Sanchez promptly notified David Jordan (Jordan), Acting

Chief Counsel, about the Thompson settlement.

Sanchez and Jordan

agreed that the Tax Court had to be notified immediately.

Bakutes prepared a motion that was filed in this Court on

June 9, 1992, seeking leave to vacate the decisions entered in

the Thompson, Cravens, and Rina test cases, which had not become

final and had not been appealed.

Unlike the Thompsons and the

Cravenses, Rina had not entered into a settlement agreement with

McWade and Sims, and the decision that had been entered in his

case was in accordance with Dixon II.

In the motion, respondent

acknowledged that the existence of the secret agreements and “the

failure to divulge same to the Court and the other Test Case

petitioners prior to the trial raises questions which should be

addressed by the Court and the parties after a full hearing

before the Court.”

Respondent requested the Court to conduct an

- 34 evidentiary hearing to determine whether the agreements with the

Cravenses and the Thompsons had affected the trial of the test

cases or the ensuing decisions of the Court.

On or about June 11, 1992, Sanchez decided that McWade and

Sims should no longer have any authority over the Kersting

project and that all Kersting project cases should be assigned to

other attorneys who were familiar with the Kersting project.

Bakutes accordingly reassigned the 14 test case dockets to Thomas

A. Dombrowski (Dombrowski) and the nontest cases to Henry E.

O’Neill (O’Neill).

On June 22, 1992, the Court granted respondent’s motions to

vacate in the Thompson and the Cravens cases.

The Court ordered

the parties within 30 days to file agreed decisions or otherwise

move as appropriate.

The Court denied respondent’s request for

an evidentiary hearing.

In a separate order entered on the same

date, the Court denied respondent’s motion to vacate the decision

in the Rina test case, stating:

The Court has reviewed the testimony of Cravens, the

testimony of Thompson, the stipulated facts and

stipulated exhibits relating to the Cravenses and the

Thompsons, and the exhibits offered through Thompson as

a witness. The Court finds that these reviewed items

had no material effect on the opinion which the Court

filed on December 11, 1991, as that opinion relates to

petitioner Rina. If the reviewed items were stricken

from the record, the Court would file an opinion in all

material respects like the opinion it filed on December

11, 1991 (with the exception of certain portions

relating specifically and expressly to the Cravenses or

the Thompsons), and the Court’s findings, analyses, and

- 35 conclusions relating to petitioner Rina would remain

the same. * * *

The Court’s order denying respondent’s motion to vacate the

decision in the Rina case was consistent with this Court’s

holding in Chao v. Commissioner, 92 T.C. 1141 (1989), that the

Court will not vacate a decision if a new trial would not result

in a different decision.

Rina appealed his decision to the Court

of Appeals for the Ninth Circuit, where appeals in the other

Kersting project test cases were pending.

The same day the Court acted on respondent’s motions to

vacate, Bakutes telephoned DeCastro to tell him that the

decisions in the Thompson cases had been vacated.

During the

call, DeCastro told Bakutes that in 1988 McWade had reduced the

Thompsons’ deficiencies to keep the Thompsons in the test case

trial.

Although DeCastro had earlier told Bakutes that

attorney’s fees had not figured in the settlement, he admitted in

this conversation that the deficiencies had been reduced to pay

the Thompsons’ legal fees for his representation of them in the

test case trial.

During the summer of 1992, Jordan directed two senior

attorneys in the Tax Litigation Division in the National Office,

Thomas J. Kane (Kane) and Steven M. Miller (Miller), to

investigate the Thompson settlement on behalf of the National

Office.

Kane and Miller conducted in-house depositions and

- 36 interviewed various individuals who had participated in the test

case trial and the Thompson settlement.

Bakutes assigned Dombrowski to help Kane and Miller in their

investigation.

Dombrowski’s immediate problem was how to respond

to this Court’s order of June 22, 1992, that within 30 days the

parties file agreed decisions or otherwise move.

On June 24, 1992, Marlene Gross (Gross), an official in the

National Office, called Bakutes and informed him that the

Department of Justice (DOJ) would not seek remand of the test

cases that had been appealed.

The DOJ’s decision was based on

the Tax Court’s refusal to vacate the decision in the Rina case.

That refusal indicated to the DOJ officials that the Tax Court

would probably reject any request by respondent to vacate the

Court’s decisions in the other test cases.

Gross also reported

to Bakutes that the DOJ, specifically the Tax Division’s

Appellate Section Chief Gary Allen, wished to offer the same

settlement to the test case petitioners on appeal that the

Thompsons had received:

a 65-percent reduction in deficiencies

(a rough approximation of the reduction of the Thompsons’

originally determined deficiencies from $79,293.52 to the $30,000

figure finally agreed upon).

Bakutes was opposed to settling the

appealed cases on that basis, and no settlement offer on that

basis was made to the test case petitioners on appeal.

- 37 In July 1992 DeCastro filed a motion for entry of decision

in the Thompson cases in accordance with the final agreement he

had reached with McWade shortly before trial; i.e., deficiencies

of zero, $15,000, and $15,000 for 1979-81, respectively.

August 20, 1992, respondent filed objections to DeCastro’s motion

for entry of decision, together with respondent’s own motions for

entry of decision and an accompanying memorandum.

Respondent’s

motion acknowledged that the Thompsons were entitled to the

original 18.8-percent reduction settlement agreed to by McWade

and DeCastro in December 1986 and sought decisions to that

effect; respondent argued that the “New Agreement”, intended to

pay the Thompsons’ legal fees, was unauthorized and had no legal

basis.

Respondent’s 11-page motion for entry of decision, with a

15-page supporting memorandum, set forth the facts regarding the

Thompson settlement that had been discovered by IRS senior

officials.

Respondent informed the Court that before the test

case trial McWade and Sims had agreed to sweeten the prior

settlements of the Thompson cases by further reducing the

Thompsons’ deficiencies in order to compensate them for their

projected attorney’s fees.

As respondent explained to the Court,

McWade and Sims had agreed with DeCastro that

All settlement refunds in excess of the amounts

provided by the December 1986 agreement would go

ultimately to the benefit of Mr. DeCastro for payment

of his legal fees and costs. Mr. DeCastro would be

- 38 paid solely from amounts refunded by the Service to

Thompson. * * * This “New Agreement”, in sum and

substance, if not explicitly, was designed, and

constituted an agreement by Messrs. Sims and McWade to

pay Mr. DeCastro’s legal fees and expenses.

Respondent’s motion papers compared the amounts of the

Thompsons’ deficiencies originally determined for the 3 years at

issue, totaling $79,293.52, with the unauthorized “New Agreement”

reducing the deficiencies to zero, $15,000, and $15,000, or

total deficiencies of only $30,000, thus generating the refunds

used to pay DeCastro’s legal fees.

These figures, without more,

indicate that the “New Agreement” represented a 62-percent

reduction of the deficiencies respondent originally determined.

In respondent’s memorandum of points and authorities in

support of respondent’s motion for entry of decision, respondent

acknowledged that “counsel for both parties owed a special

obligation of candid disclosure to this court given the highly

unusual circumstances which were of their own making.”

Respondent acknowledged that the Rules of this Court and the

Model Rules of Professional Conduct require the utmost candor to

the Court, “which duty would proscribe misleading the court by

silence, inaction, or failure to apprise the court of any

material fact that may affect the proceeding before the court.”

Respondent further acknowledged:

as officers of the court, both the District Counsel

attorneys and petitioners’ counsel owed a special duty

to disclose to this court that they had entered into an

agreement to settle the litigation and that District

- 39 Counsel William Sims agreed in substance to pay the

litigation expenses of his adversary. See Booth v.

Mary Carter Paint Co., 202 So. 2d 8 (Fla. Dist. Ct.

App. 1967); 2 Moore’s Fed. Practice Par. 23.23. In

Reager v. Anderson, 371 S.E. 2d 619, 630 (W. Va. 1988),

the court, commenting upon the duty of candor to the

court, observed that “(i)t is critical to the fair

conduct of the trial to disclose promptly the

settlement terms to the court and to opposing counsel

so that the court can decide whether the agreement is

valid, and if so, what measure will be taken to ensure

that the nonsettling party(ies) will not be

prejudiced.” We believe that this is particularly

important where the settling party remains in the

litigation, testifies with respect to the issues, and

his attorney appears to be an advocate adverse to the

party paying the fees.

On August 26, 1992, the Court entered orders and decisions

in the Thompson cases summarily denying respondent’s motion for

entry of decision, granting DeCastro’s motions for entry of

decision, and entering decisions in accordance with the final

Thompson agreement.

Respondent did not appeal the decisions the Court entered in

the Thompson and the Cravens cases.

As a result, those decisions

became final, while Rina and the other test case petitioners, who

had appealed the decisions entered in their cases, added the

newly revealed facts about the misconduct of respondent’s

attorneys to the grounds for their appeals.

The rationale of the Office of Chief Counsel for not

appealing the Tax Court’s entry of the decisions giving effect to

the Thompson settlement was set forth in a memorandum, dated

September 8, 1992, prepared by Kane:

- 40 The Chief Counsel [Abraham N.M. Shashy, Jr.] and Deputy

Chief Counsel have concluded that, under the

circumstances, we have completely fulfilled all

applicable ethical and legal obligations with respect

to this issue and this litigation. They have also

concluded that given the fact that the conduct on the

part of our attorneys is significantly less than

exemplary, there is nothing to be gained by further

prolonging this aspect of the Kersting litigation.

On September 30, 1992, Judge Goffe terminated his recall

status as a Senior Judge and retired from the bench.

The Chief

Judge of the Tax Court reassigned the Kersting project cases to

Judge Renato Beghe.

In October 1992 Izen and Robert Patrick Sticht (Sticht),

representing various nontest case petitioners, filed separate

motions with the Tax Court to intervene in the Thompson and

Cravens cases, before the newly entered decisions in those cases

had become final.

Sticht and Izen maintained that their clients

should be allowed to intervene in those cases in order to assert

that McWade had committed fraud on the Court by arranging the

Thompson settlement and failing to inform the Court or the other

parties.

On November 6, 1992, we denied the motions to intervene.

Izen and Sticht filed notices of appeal of our denials of their

intervention motions, again alleging fraud on the Court.

- 41 III. Kersting’s Responses to Dixon II and Discovery and

Disclosure of the Secret Settlements: Letters to Kersting

Program Participants and Formation of the Kersting Defense

Group

After the Court filed Dixon II, Kersting kept the

participants in his programs informed about the status of the

test cases.

In February 1992, Kersting sent a lengthy “Dear

Friend” letter to the participants in his programs, informing

them that Izen was preparing an appeal of Dixon II in the test

cases to be filed with the Court of Appeals for the Ninth

Circuit.

Kersting’s letter also said he had formed a defense

team of attorneys and included with the letter a copy of the

business card of “R.A.J. Limited, Robert Alan Jones, Esq.,

President”.

Subsequently, Attorneys Robert Alan Jones (Jones) and Declan

J. O’Donnell (O’Donnell) announced the Henry Kersting Tax Defense

Group.

A defense group brochure created in May 1992 describes the

legal services O’Donnell and Jones would offer to Kersting program

participants.

The brochure included a description of the

qualifications and practice backgrounds of O’Donnell and Jones,

along with retainer agreements and copies of relevant memoranda

and correspondence.

One such memorandum, entitled “Status of the

Kersting Cases”, signed by O’Donnell and dated May 12, 1992, said

that most of the Kersting program participants had executed

piggyback agreements to be bound by the results in the test cases

and that the test cases had been decided for the Government.

- 42 said that the deadline for filing an appeal was June 11, 1992, and

that Izen was representing the test case petitioners and would

handle the appeal.

After the Court had denied respondent’s motions to vacate the

Rina decision and for an evidentiary hearing and had vacated the

original Thompson and Cravens decisions, Jones and O’Donnell wrote

Dombrowski a joint letter dated June 24, 1992.

They informed

Dombrowski that they represented approximately 100 Kersting

project taxpayers and that they understood Dombrowski had replaced

McWade as respondent’s counsel because of an ethical concern

regarding the impropriety of the secret settlements with the

Cravenses and the Thompsons.

The letter acknowledged that the Court had concluded that the

newly disclosed “Contingent Settlements” would not change its

opinion in any material way and had denied a motion to vacate

decision filed in a case that was not on appeal.

The letter also

stated that motions to remand were pending before the Court of

Appeals for the Ninth Circuit in cases that had been appealed.

By letters dated June 24 and August 12, 1992, Jones and

O’Donnell asked Dombrowski to provide informal discovery regarding

the Thompson and Cravens settlements.

Respondent refused their

informal discovery requests and did not allow them to participate

in any of respondent’s in-house investigations.

- 43 In a letter dated July 31, 1992, Kersting informed the

Kersting program participants that Izen and Sticht were “exposing

the government’s fraud and perfidy in a secret deal between

Cravens and Thompson on the one hand, and IRS attorney McWade (and

other government officials) on the other hand.”

Kersting

explained his version of the misconduct of the Government’s

attorneys as follows:

“As many of you already know, the growing

scandal in the ‘piggyback’ cases involves a settlement in favor of

Cravens/Thompson in exchange for their damaging testimony and

exhibits that were all put together as part of a prearranged plan

to influence and persuade Judge Goffe to rule against us.”

On September 14, 1992, Kersting wrote another “Dear Friend”

letter informing the Kersting participants of further

developments.

Kersting said the misconduct of Sims, McWade, and

DeCastro “threw the appeals schedule into turmoil and motions had

to be filed to ask for an extension of time for filing the

Appeal.”

Kersting advised them to ask for “the same concessions

arranged by the Revenue Service to Thompson and Cravens.

arrangement whereby $100,000.00 of taxes allegedly owed were

reduced to a mere $15,000.00.”

This “Dear Friend” letter

concluded by disclosing that relations had soured between Kersting

and the “Henry Kersting Tax Defense Group” of O’Donnell and Jones.

- 44 IV.

Respondent’s Posttrial Settlement Offer

In July 1992 respondent’s National Office began in-house

discussions about offering a 7-percent reduction settlement to

Kersting project petitioners who were bound by the test cases

through piggyback agreements.

On September 9, 1992, Dombrowski sent a draft of a proposed

settlement offer letter (Dombrowski draft) to Paul Zamolo, Acting

Deputy Regional Counsel.

The Dombrowski draft explained that the

Tax Court had issued its Dixon II opinion disallowing the interest

deductions, imposing additions to tax for negligence under section

6653 and substantial understatement of tax under section 6661, and

finding that the increased interest rate under section 6621(c)

applied.

The Dombrowski draft stated that five of the test case

petitioners (Dixon, DuFresne, Hongsermeier, Owens, and Young) were

appealing their cases in the Ninth Circuit, but that the appeals

had not yet been resolved.

The Dombrowski draft further stated

that respondent had moved to vacate the decisions in the Cravens,

Rina, and Thompson test cases because “it appeared that a

settlement agreement had been reached with two [sic] of the test

case petitioners, the Cravens [sic] and the Thompsons, prior to

the trial of the test cases.”

The Dombrowski draft then described

the action taken by the Court as follows:

The Tax Court granted the Motions to Vacate

Decision which were filed in the Thompson and Cravens

cases. The Court directed the parties to either file

agreed decisions or motions regarding the decisions to

- 45 be entered in the cases. Agreed decisions were filed in

the Cravens’ cases reflecting the Cravens’ pre-trial

acceptance of the standard Kersting settlement offer.

The parties were unable to agree on the decisions to be

filed in the Thompson cases. Thereafter, motions for

entry of decision were filed by both the government and

the Thompsons. The Tax Court granted the Thompsons’

motions and entered decisions accordingly.

The Court denied the Motion to Vacate Decision

filed in the third case involving petitioner Ralph J.

Rina. In denying the Motion to Vacate Decision the

Court stated that the testimony and evidence offered by

Mr. Thompson and Mr. Cravens had no material effect on

the opinion as it related to Mr. Rina and therefore the

Court’s findings, analyses and conclusions relating to

him would remain the same. Accordingly, all Kersting

interest deductions were disallowed and all additions to

tax were sustained as to Mr. Rina. * * *

* * * It is the Service’s belief that the trial

Court’s disallowance of interest deductions and the

imposition of the additions to tax will be upheld on

appeal.

The Dombrowski draft then stated that the IRS had decided to

renew its previous offer of the 7-percent settlement including the

burnout and enclosed a form on which the taxpayer could indicate

his/her acceptance of the offer.

The Dombrowski draft stated:

“the offer applies only to adjustments resulting from your

participation in the various Kersting programs referred to above.

Any other adjustments raised in your case will be considered on an

item by item basis and will be settled or litigated as

appropriate.”

A September 30, 1992, shorter draft of a settlement proposal

prepared by Sanchez (Sanchez draft) gave much less detail than the

Dombrowski draft.

The Sanchez draft referred to the Tax Court’s

- 46 decision but did not name the case or cite Dixon II.

It only

identified Cravens as one of two test cases in which “some

irregular and undisclosed agreements” had been reached.

The

Sanchez draft stated that the Tax Court had concluded that the

outcome of the trial was unaffected by the irregular activity and

that decisions had been entered in the two test cases enforcing

the undisclosed agreements.

The Sanchez draft did not identify

any of the other test cases or mention that some of those cases

were being appealed.

The Sanchez draft stated:

We believe that the Cravens situation is

indistinguishable from your own.

We have determined that the Cravens [sic] in good

faith believed that they had a valid settlement

agreement prior to the trial. Because they were not

represented by counsel, they could not be expected to

have detected any irregularity on our part.

Because the Cravens [sic] received the benefit of

this offer even after trial, we believe that fundamental

fairness compels that you should receive the same

treatment. Therefore, we will apply the benefits of

that treatment to your case.

The Sanchez draft stated that the adjustments to the

taxpayer’s account with the IRS would be made administratively and

required no further action by the taxpayer.

A third draft dated October 26, 1992, prepared by Kane (Kane

draft), was also less detailed than the Dombrowski draft.

The

Kane draft cited Dixon II but did not identify any of the other

test cases.

The Kane draft stated that two of the test case

- 47 petitioners had entered into settlement agreements that had not

been disclosed to the other test case petitioners or the Tax Court

but did not identify the taxpayers who had entered into the

undisclosed settlement agreements.

The Kane draft stated that the

Tax Court had concluded that the outcome of the trial was

unaffected by the testimony of the test case petitioners who had

settled their cases.

The Kane draft stated:

“This means that the

opinion of the Tax Court, as it affects you, remains unchanged.”

The Kane draft did not disclose that the Dixons and some of the

other test case petitioners had filed appeals with the Court of

Appeals for the Ninth Circuit.

The Kane draft stated that “fundamental fairness dictates

that you be afforded an opportunity to settle your case on similar

grounds”.

The Kane draft, like the Sanchez draft, indicated that,

if the taxpayer’s case had been settled, the adjustments would be

made administratively without requiring further action from the

taxpayer.

If the case was still pending in the Tax Court, the

taxpayer had 60 days to accept the offer.

The Kane draft stated

that acceptance of the offer would “preclude any further

challenges or appeal with respect to the merits of the Dixon

opinion as applied to your case(s).”

On January 8 and 29, 1993, respondent made mass mailings

extending a global settlement proposal to all known Kersting

project nontest case petitioners and their counsel (posttrial

- 48 settlement offer).

The posttrial settlement offer informed

petitioners that the Court had issued its opinion sustaining all

the adjustments and cited Dixon II.

It explained that, after the

trial of the test cases:

It subsequently came to our attention that two of

the test case petitioners had entered into settlement

agreements with the Service prior to the trial, and that

these agreements were not disclosed to the Tax Court or

the other test case petitioners. The settlement

agreements provided that these particular test case

petitioners could proceed to trial, but would receive

the benefit of the better of their pretrial settlement

agreement or the results of the trial. The Tax Court

has since been advised of this situation and has

concluded that the outcome of the trial was not affected

by the testimony of these test case petitioners. This

means that the Tax Court opinion, as it pertains to

other Kersting cases, remains unchanged. However, in

light of these recent developments, we have concluded

that in fairness all petitioners be afforded an

opportunity to settle their cases.

In general, the posttrial settlement offer represented a

revival of the official project settlement that respondent had

offered during 1982-88.

It permitted taxpayers to resolve their

cases by agreeing to pay deficiencies that were 7 percent less

than those determined in their deficiency notices.

Respondent

would impose no penalties or additions to tax, and taxpayers would

pay interest only at the generally applicable (i.e., nontax-motivated) rate under section 6621(a).

The posttrial

settlement offer did not include the burnout.

The posttrial settlement offer further stated:

“Acceptance

of this settlement offer will preclude any further challenge or

- 49 appeal with respect to the Kersting programs or the merits of the

Dixon opinion.

Any other issues involved in this case will be

resolved separately.”

Taxpayers were given 60 days within which

to accept or reject the posttrial settlement offer.

The Lewis and Liu Settlements

In a letter dated March 11, 1993, O’Donnell informed

respondent’s counsel that the Lewises had decided to accept the

posttrial settlement offer.16

Thereafter, respondent forwarded a

stipulated decision document to O’Donnell and Jones reflecting a

disposition of the Lewises’ cases on the terms set forth in the

posttrial settlement offer.

On May 17, 1993, O’Donnell signed the

decision documents in docket Nos. 15673-87 and 18551-88; on May

18, 1993, Jones signed the decision document in docket No. 2942988.

On June 16, 1993, O’Neill signed the Lewises’ decision

documents on behalf of respondent.

On June 23, 1993, the Court

entered the decisions in the Lewises’ three dockets.

On September

22, 1993, the decisions became final under section 7481.

The Lius, proceeding pro sese,17 also accepted the posttrial

settlement offer.

On March 10, 1993, the Court entered the

O’Donnell and Jones had entered their appearances on

behalf of the Lewises in the present cases on July 6, 1992.

The Lius were represented by Thomas P. Dunn from May 26,

1987, to July 21, 1989. Their present counsel, Matthew K. Chung,

entered his appearance in these proceedings on Oct. 18, 2004,

when he filed the Lius’ motion for leave to file motion to vacate

their stipulated decision.

- 50 stipulated decision in the Lius’ case, docket No. 48690-86.

June 8, 1993, the decision became final under section 7481.

When respondent submitted the stipulated decision documents

obtained through the posttrial settlement offer to the Tax Court

and asked the Court to enter those stipulated decisions,

respondent did not file a copy of the posttrial settlement offer

with the Court.

VI.

Disciplinary Actions Against McWade and Sims

On July 29, 1993, respondent’s management sent notices of

proposed disciplinary action to McWade and Sims.

asserted that McWade and Sims had violated:

The notices

(1) Department of the

Treasury Minimum Standards of Conduct, section 0.735-30(a)(2) (an

employee shall avoid any action which might result in or create

the appearance of giving preferential treatment to any person);

(2) Department of the Treasury Minimum Standards of Conduct,

section 0.735-30(a)(6) (an employee shall avoid any action that

might adversely affect the confidence of the public in the

integrity of the Government); and (3) IRS Rule of Conduct 214.5

(an employee will not intentionally make false or misleading oral

or written statements in matters of official interest).

The

notices proposed to suspend both McWade and Sims for 14 calendar

days without pay.

The Notices of Proposed Disciplinary Action to McWade and

Sims listed the following reasons for the proposed disciplinary

- 51 actions:

(1) Negotiating an unauthorized settlement agreement

with the Thompsons; (2) basing the Thompson settlement on

unaudited and insufficiently documented losses from an unrelated

shelter; (3) allowing the Thompsons a settlement that provided

them more favorable treatment than other taxpayers;

(4) compensating the Thompsons for their attorney’s fees; and

(5) not informing the Tax Court of the Thompson settlement

arrangements.

McWade and Sims were both suspended for 2 weeks without pay

and transferred from the Honolulu Division.

Sims accepted these

disciplinary actions and was transferred to the San Francisco

Regional Counsel’s Office, where he was assigned nonsupervisory

duties as a Special Litigation Assistant in the General

Litigation area.

Rather than accept a transfer to the Los

Angeles District Counsel’s office, McWade retired from the IRS,

effective October 2, 1993.

On April 1, 1999, the day immediately following the issuance

of the Dixon III opinion, we referred the misconduct of Sims,

McWade, and DeCastro to the Committee on Admissions, Ethics, and

Discipline of the Tax Court.

On April 22, 2003, following the

issuance of the Court of Appeals opinion in Dixon V and entry of

its primary mandate, the Tax Court, through the Committee on

Admissions, Ethics, and Discipline, issued orders to Sims,

McWade, and DeCastro to show cause why they should not be

- 52 suspended or disbarred from practice before the Court or

otherwise further disciplined.

On July 1, 2003, DeCastro

resigned from practice before the Court.

The Tax Court, acting on the orders to show cause and the

recommendations of the Committee on Admissions, Ethics, and

Discipline, suspended McWade and Sims from practice before the

Court for 2 years, commencing February 20, 2004.

The Arkansas

State Bar suspended Sims’s license to practice law for 1 year in

February 2004, and the Oregon State Bar suspended McWade’s

license to practice for 2 years in August 2004.

The Director of

the IRS Office of Professional Responsibility suspended McWade

and Sims indefinitely from practice before the IRS, effective

June 9, 2004.18

VII. Appeals to the Court of Appeals for the Ninth Circuit and

Proceedings on Remand

Respondent did not appeal the decisions this Court entered

in the Thompson and the Cravens cases in accordance with the

secret settlement agreements.19

closed.

As a result, those cases were

The remaining test case petitioners, including Rina,

appealed the decisions entered in their cases to the Court of

Following what Attorney Michael Louis Minns interpreted as

a suggestion or order by a member of the panel that heard oral

argument on the appeal that resulted in Dixon V, Minns filed the

complaints that resulted in the disciplinary actions by the

Arkansas and Oregon Bars and the IRS Office of Professional

Responsibility.

See the Kane memorandum dated Sept. 8, 1992, supra p. 40.

- 53 Appeals for the Ninth Circuit; they included facts about the

misconduct of respondent’s attorneys as grounds for their

appeals, which they characterized as fraud on the court.

Additionally, Izen and Sticht separately appealed to the Court of

Appeals for the Ninth Circuit our orders denying their motions to

intervene in the Thompson and Cravens cases on behalf of various

Kersting project nontest case petitioners.20

Ninth Circuit Remand: DuFresne v. Commissioner and

Adair v. Commissioner

In DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994),

the Court of Appeals for the Ninth Circuit vacated the decisions

entered against the test case petitioners (other than the

Thompsons and Cravenses) on the ground that the misconduct of

McWade and Sims required further inquiry.

The Court of Appeals noted that in respondent’s motions to

vacate decision filed in the Tax Court respondent had “presented

a telling case of corruption of the process of the tax court and

the rights of both the government and the taxpayers” and that the

parties wrongly believed that the test cases were fairly

representative of all the other cases and were not sham or

collusive proceedings.

The Court of Appeals found that the

taxpayers, the Government, and the Tax Court had all been cheated

Izen and Sticht also filed appeals of our orders denying

their motions to intervene in the Thompson and Cravens cases in

the Courts of Appeals for the Second and Tenth Circuits. Those

appeals were dismissed for procedural reasons and not on the

merits.

- 54 by the conduct described in the appeal; i.e., that a secret

settlement agreement entered into between respondent and the

Thompsons was contingent upon the Thompsons’ not prevailing in

their cases, and that, in effect, the Government agreed to pay

the Thompsons’ legal fees, and that the Cravenses had entered

into a similar agreement.

The Court of Appeals also noted that

Rina had alleged, in a motion for reconsideration in the Tax

Court, that the Thompsons’ attorney (who was the main beneficiary

of the settlement) was privy, at his insistence, to the test case

trial strategy, read counsel’s trial notes, and overheard

communications with clients.

The Court of Appeals stated that it could not determine from

the appellate record “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.

Arizona v. Fulminante, 499 U.S. 279, 309 (1991).”

See

Id. at 107.

The Court of Appeals vacated the decisions entered in the

remaining test cases and remanded the cases to this Court with

directions to hold an evidentiary hearing to determine the full

extent of the misconduct of McWade and Sims.

The Court of

Appeals also directed the Tax Court to consider on the merits all

motions of intervention filed by affected parties and stated that

all subsequent appeals would be scheduled before the same panel.

- 55 In Adair v. Commissioner, 26 F.3d 129 (9th Cir. 1994), an

unpublished opinion filed the same day as the DuFresne opinion,

the DuFresne panel also dismissed the Kersting project nontest

case petitioners’ appeals of our orders denying their motions to

intervene in the Thompson and Cravens cases.

Notwithstanding (1)

the Kersting project nontest case petitioners’ allegations that

the misconduct of the Government attorneys was a fraud on the Tax

Court, (2) the DuFresne panel’s conclusions in DuFresne that the

process of the Tax Court had been corrupted and that the test

case trial was a sham or collusive proceeding, and (3) the

holding in Toscano v. Commissioner, 441 F.2d 930, 934 (9th Cir.

1971), vacating 52 T.C. 295 (1969), that the Tax Court has

jurisdiction to set aside a final decision where a fraud has been

perpetrated on the Court, the DuFresne panel held that the

decisions entered in the Cravens and Thompson cases were final

and that the Tax Court lacked jurisdiction to vacate them, citing

Billingsley v. Commissioner, 868 F.2d 1081, 1084 (9th Cir. 1989).

Evidentiary Hearing and Opinions on DuFresne Remand:

Dixon III and IV

In May-June 1996 we conducted the evidentiary hearing

directed by the Court of Appeals in DuFresne.

To give effect to

the directive of the Court of Appeals that the Tax Court consider

on the merits all motions of intervention filed by affected

parties, we ordered the consolidation of 10 nontest cases, each

- 56 represented by Izen, Sticht, or Jones, with the remaining test

cases for purposes of the evidentiary hearing.21

Shortly before the evidentiary hearing, held in May-June

1996, the parties discovered that decisions entered in the

Alexander cases zeroed out the Alexanders’ deficiencies for 197477.

In Dixon III, filed March 30, 1999, we made detailed

findings of fact concerning McWade’s and Sims’s misconduct during

the Kersting test case proceedings.

Our ultimate findings

included the following.

(1) McWade and Sims negotiated a series of contingent

settlement agreements with DeCastro in respect of the Thompsons’

tax liabilities in advance of the trial of the test cases.

The

final Thompson settlement agreement provided for a reduction in

the Thompsons’ tax liabilities for the purpose of generating

refunds to pay DeCastro’s attorney’s fees.

(2) McWade and Sims negotiated a contingent settlement

agreement with John R. Cravens (Cravens) in respect of the

Cravenses’ tax liabilities in advance of the trial of the test

cases.

McWade and Sims misled Cravens about the nature and legal

The Gridleys and the Fleers, Kersting project nontest case

petitioners who were represented by O’Donnell, were originally

included in the consolidation for the evidentiary hearing.

However, before the hearing, we severed their cases from the

consolidation, at O’Donnell’s request, so they could

independently pursue their summary judgment motions described

infra Part VII.C.

- 57 effect of his settlement and his need for counsel at the trial of

the test cases.

In so doing, they foreclosed the possibility

that the Cravenses would obtain counsel, thereby reducing the

effectiveness of Cravens’s testimony and presentations to the

Court from the point of view of all test case petitioners.

The

Cravenses’ lack of counsel also reduced the likelihood that they

would inform counsel for test case petitioners that their cases

had settled.

(3) Before the trial of the test cases, McWade intentionally

misled the Court, with the complicity of DeCastro, by not

disclosing the settlement of the Thompson cases when he moved to

set aside the Thompson piggyback agreements.

At the trial of the

test cases, Sims, McWade, and DeCastro intentionally misled the

Court about the status of the Thompson cases by not disclosing

that they had been settled.

They intentionally misled the Court

in similar fashion about the Cravens cases.

McWade allowed

Alexander to offer misleading testimony denying that his tax

liabilities would be zeroed out in exchange for his testimony and

other assistance to McWade.

(4) Izen had no knowledge, before and at the trial of the

test cases through the times that the Court issued the Dixon II

opinion and entered the initial decisions in the test cases, that

the Thompsons and the Cravenses had entered into settlement

agreements with McWade.

However, DeCastro did not act as a

- 58 Government “mole” during the trial of the test cases or convey

any of Izen’s trial strategies or confidential information to the

Government.

Having made detailed findings of fact describing the

misconduct of the Government attorneys and DeCastro during the

test case proceedings, we evaluated that misconduct under Arizona

v. Fulminante, 479 U.S. 279, 309-310 (1991), as mandated by the

Court of Appeals, citing Chapman v. California, 386 U.S. 18

(1967), for the proposition that the presence of a structural

defect in a criminal trial requires automatic reversal of the

conviction and a new trial; we held that the misconduct of the

Government attorneys did not create a structural defect that

would invalidate the judgments in the test cases.22

We reasoned

that the Thompson and Cravens settlements did not alter the basic

In Dixon III, we observed that the term “structural

defect” normally refers to the violation of a fundamental

constitutional right occurring during a criminal trial that

affects the very framework within which the trial proceeds so

that the trial cannot reliably serve its function as a vehicle

for determination of guilt or innocence. Not all constitutional

errors occurring during a trial result in a structural defect in

the proceedings. In fact most constitutional errors,

characterized as lesser “trial errors”, are amenable to harmlesserror analysis. A constitutional violation is harmless if it did

not have a “‘substantial and injurious effect or influence’” in

determining the jury’s verdict. Rice v. Wood, 77 F.3d 1138, 1144

(9th Cir. 1996) (quoting Brecht v. Abrahamson, 507 U.S. 619, 623

(1993)). In civil cases an error related to admission of

evidence or attorney misconduct is considered harmless if there

is no prejudicial effect and/or the error did not affect the

judgment. See Chalmers v. City of Los Angeles, 762 F.2d 753,

761-762 (9th Cir. 1985); see also Mateyko v. Felix, 924 F.2d 824,

827-828 (9th Cir. 1991) (new trial is warranted only if

misconduct affected the verdict).

- 59 framework within which the trial of the test cases was conducted

and that the outcome of the retrial of the test cases would be

the same if we were to order a new trial.

Next we considered the merits of the motions of intervention

filed by Kersting project nontest case petitioners whose cases

were bound by Dixon II.

We concluded that the Government

misconduct did not provide any other basis for invalidating the

Court’s decisions in the remaining test cases or for setting

aside the piggyback agreements.

In Dixon III we found that the Kersting project nontest case

petitioners who signed piggyback agreements received what they

bargained for, an opinion and decisions on the merits in Dixon

II.

We reviewed the Court’s Dixon II opinion and then considered

the relative importance of the testimony and evidence of the

Thompsons, the Cravenses, and the Alexanders to the Court’s

holdings in Dixon II.

In Dixon II the Court had relied upon

substantial objective evidence in concluding that the test case

petitioners had no business purpose for entering into the

Kersting programs other than tax avoidance and that the

transactions lacked economic substance.

In Dixon III we held that the Government misconduct resulted

in harmless error in the trial of the test cases insofar as the

Court had concluded in Dixon II that:

(1) The Kersting

transactions were shams; (2) the Kersting promissory notes did

- 60 not constitute genuine debt; and (3) interest on Kersting loans

was not paid within the meaning of section 163(a).

Because the outcome in the trial of the test cases would not

have changed had the Cravens and Thompson cases been removed from

the test case array, we concluded that the taxpayers were not

entitled to a new trial, concluding that the misconduct resulted

in harmless error rather than reversible error.

See Arizona v.

Fulminante, supra at 307-308; Drobny v. Commissioner, 113 F.3d

670, 678 (7th Cir. 1997), affg. T.C. Memo. 1995-209.

In Dixon III we also held that the Government misconduct in

the trial of the test cases did not amount to fraud,

misrepresentation, or misconduct under rule 60(b)(3) of the

Federal Rules of Civil Procedure or fraud on the Court that would

require the Court either to order a new trial or to enter

decisions eliminating all tax liability.

In Dixon III we found that the test case petitioners were

afforded a fair trial despite the Government misconduct,23 and

therefore justice would not be served if we were to adopt the

extraordinary remedy of renouncing the Court’s deficiency

Although we observed that respondent promptly reported

McWade’s and Sims’s misconduct to the Court upon discovery and

that respondent’s overall conduct in the proceedings exhibited

respondent’s institutional good faith, Dixon IV, 79 T.C.M. (CCH)

1803, 1810, 2000 T.C.M. (RIA) par. 2000-116, at 2000-641; Dixon

III, 77 T.C.M. (CCH) 1630, 1720, 1999 T.C.M. (RIA) par. 99,101,

at 99-652, we had no occasion in the Dixon III and IV proceedings

to examine or address the circumstances surrounding respondent’s

posttrial settlement offer.

- 61 determinations in Dixon II, thereby eliminating all tax liability

of the taxpayers.

Our conclusion that the misconduct was not a

fraud on the Court appeared to us to be consistent with the

DuFresne panel’s holding in Adair v. Commissioner, 26 F.3d 129

(9th Cir. 1994), that the decisions in the Cravens and Thompson

cases were final and that the Tax Court lacked jurisdiction to

vacate them.

Under Ninth Circuit precedent, the Tax Court has

jurisdiction to set aside a final decision where a fraud has been

perpetrated on the Court.

Toscano v. Commissioner, 441 F.2d at

934.

We also concluded that the piggyback agreements executed by

Kersting project nontest case petitioners should not be set aside

under the theory of fraudulent inducement or for breach of

contract.

Although we held in Dixon III that Kersting project test

case and nontest case petitioners were not entitled to a new

trial or the elimination of all their tax liabilities, we

recognized that the misconduct of McWade and Sims had harmed the

judicial process, and we found it appropriate to impose sanctions

against respondent under Rule 123(a).

We held that Kersting

project petitioners who either had not had decisions entered in

their cases or whose decisions had not yet become final were not

liable for the interest component of the addition to tax for

- 62 negligence under section 6653(a)(2) or (1)(B) or interest

computed at the increased rate prescribed in section 6621(c).

In Dixon IV we imposed additional sanctions pursuant to

section 6673(a)(2)(B) by ordering respondent to pay the

attorney’s fees the Kersting project petitioners had incurred to

investigate McWade’s and Sims’s misconduct and present the

evidence of that misconduct to the Court.

We also held that

further sanctions against respondent were not warranted to reduce

Kersting project petitioners’ tax liabilities to match

respondent’s earlier 20-percent settlement offer.

The remaining

test case petitioners (except the Thompsons, the Cravenses, and

Rina24) and the Kersting project nontest case petitioners who had

participated in the evidentiary hearing mandated by DuFresne

appealed Dixon III and IV to the Court of Appeals for the Ninth

Circuit.

Gridley v. Commissioner

The Gridleys and the Fleers, nontest case Kersting project

petitioners who were bound by the outcome of the test cases

through piggyback agreements, filed motions for summary judgment

that they were entitled to entry of decisions providing for zero

deficiencies, consistent with the decision entered in the

Thompsons’ case for 1979, docket No. 19321-83 (all versions of

On June 13, 1995, shortly before the evidentiary hearing

on remand from DuFresne, Rina agreed to entry of a stipulated

decision in the amounts respondent originally determined in his

deficiency notice.

- 63 the Thompson settlement applied the burnout to provide a zero

deficiency for 1979, the Thompsons’ first taxable year), citing

Estate of Satin v. Commissioner, T.C. Memo. 1994-435, and Fisher

v. Commissioner, T.C. Memo. 1994-434.

We denied their motions in

Gridley v. Commissioner, T.C. Memo. 1997-210.

We distinguished

Estate of Satin and Fisher on the ground that the piggyback

agreements in those cases bound the taxpayers to the resolution

of the test cases “whether by litigation or settlement”, whereas

the Gridleys’ and Fleers’ piggyback agreements did not mention

settlement of the test cases.

The Gridleys and Fleers appealed

to the Court of Appeals for the Ninth Circuit; by mandate dated

May 6, 2003, the Court of Appeals remanded for further

proceedings consistent with Dixon V.25

Dixon V:

Court of Appeals Again Reverses and Remands

Consistent with the concluding statement in DuFresne v.

Commissioner, 26 F.3d at 107, that all subsequent appeals would

be scheduled before the DuFresne panel, the DuFresne panel, on

By orders entered July 11, 2000, we had certified the

Gridley and Fleer cases, as well as the cases of nontest case

Kersting project who had participated in the evidentiary hearing,

for interlocutory appeal to the Court of Appeals for the Ninth

Circuit. The Court of Appeals permitted those appeals. However,

the Court of Appeals thereafter stayed appellate proceedings in

all the appealed nontest cases, while briefing, argument, and

review of the appeals in the test cases went forward. After its

Dixon V opinion, the Court of Appeals, recognizing that the

Gridley and Fleer cases were related to the Dixon cases and the

other nontest cases, remanded the Gridley and Fleer cases and the

other nontest cases to this Court for further proceedings

consistent with Dixon V.

- 64 November 21, 2001, set the original briefing schedule for the

appeals of Dixon III and IV and received the opening and reply

On July 29, 2002, the DuFresne panel issued an order

briefs.

that “Upon reconsideration of the original panel that heard this

matter will not retain jurisdiction of any subsequent appeals.

Accordingly, the Clerk of the court is hereby directed to

schedule the current appeal in the normal course of events”.

The

appeals were assigned to a new panel of the Court of Appeals for

the Ninth Circuit (the Dixon V panel), which heard oral

arguments.

On January 17, 2003, the Dixon V panel issued Dixon V

(amended March 18, 2003), vacating and remanding the Tax Court’s

decisions in the remaining test cases.

316 F.3d 1041 (9th Cir. 2003).

Dixon v. Commissioner,

The Court of Appeals held we had

applied the wrong law in Dixon III26 and held the misconduct of

McWade and Sims was a fraud on both the Kersting project

petitioners and the Tax Court, “a fraud, plainly designed to

corrupt the legitimacy of the truth-seeking process”.

1046.

Id. at

“Fraud on the court occurs when the misconduct harms the

integrity of the judicial process, regardless of whether the

opposing party is prejudiced.”

Id. (citing

Alexander v.

Robertson, 882 F.2d 421, 424 (9th Cir. 1989)).

The Court of

Dixon V distinguished and held inapplicable the contrary

decision of the Court of Appeals for the Seventh Circuit in

Drobny v. Commissioner, 113 F.3d 670, 678 (7th Cir. 1997).

- 65 Appeals held that the fraud not only defiled the sanctity of the

Court and the confidence of all future litigants, but also

violated the rights of more than 1,300 Kersting project

petitioners who had agreed to be bound by the outcome of the test

cases.

Id. at 1047.

Rather than ordering a new trial or entering decisions

eliminating all tax liabilities of the Kersting project

petitioners, the Court of Appeals directed that terms equivalent

to those provided in the Thompson settlement agreement be

extended to “Appellants and all other taxpayers properly before

this Court”.27

Id.

The Court of Appeals left to the Tax Court’s

discretion “the fashioning of such judgments which, to the extent

possible and practicable, should put these taxpayers in the same

position as provided for in the Thompson settlement.”

Id. n.11.

On January 17, 2003, the same day as its original Dixon V

opinion, the Court of Appeals filed its primary mandate,

reversing and remanding with directions.

On May 28, 2003, the

Court of Appeals, acting through the Dixon V panel, filed a

supplemental mandate sending the test case petitioners’ appellate

fee requests to the Tax Court for a determination of entitlement

In setting forth the factual background and procedural

history of the Kersting project, the Court of Appeals noted

without comment that several hundred taxpayers had settled their

cases. Dixon V at 1043.

- 66 and, if warranted, amount.28

The supplemental mandate also stated

that the Dixon V panel “retains jurisdiction over all further

proceedings that may arise”.

Responses to Dixon V by the Office of Chief Counsel

On January 21, 2003, at the annual meeting of the New York

State Bar Association Tax Section, then IRS Chief Counsel B. John

Williams (Williams) spoke about the role of the professional

adviser in preserving the public’s confidence in our tax system.

See B. John Williams, Jr., Chief Counsel, Internal Revenue

Service, Remarks at the Meeting of the New York State Bar

Association Tax Section (Jan. 21, 2003), in 2003 TNT 15-20,

excerpts from which are set forth in appendix A.

Williams said

that he expected attorneys in the Office of Chief Counsel to

adhere to the highest professional standards.

He discussed the

fraud committed on the Tax Court in the Kersting test case

proceedings and his endorsement of the opinion and mandate of the

Court of Appeals in Dixon V.

He announced that the Office of

Chief Counsel would “expeditiously implement the Ninth Circuit’s

mandate to extend to all affected taxpayers the terms of the

settlement that were effected in the lead test case.

We will

also assure that no interest is charged on deficiencies for the

period of the appeals to the Ninth Circuit.”

See supra note 3.

Id.

- 67 Williams acknowledged that the goal of IRS attorneys cannot

be to collect the most revenue for the Government or to win cases

at all costs.

Rather, the goal is to ensure that the tax system

is administered fairly and impartially.

He recognized that

“confidence in the integrity and fairness of the tax system is

vital to our democracy.

The tax system touches more people in

this country than any other part of the government or our laws.

The loss of confidence in its integrity is the loss of confidence

in the government itself.”

Id.

On February 3, 2003, Deborah Butler, IRS Associate Chief

Counsel for Procedure and Administration, issued Chief Counsel

Notice CC-2003-008 (excerpts set forth in appendix B), reminding

all Chief Counsel attorneys, in the light of the opinion of the

Court of Appeals in Dixon V, of their obligation to adhere to the

highest ethical standards when performing their duties, including

representing the IRS before the Tax Court.

The notice reminded

Chief Counsel attorneys that their role is to ensure the uniform

application of the tax laws and the fair disposition of cases and

that, as officers of the court, they have a special duty to avoid

conduct that undermines the integrity of the adjudicative

process.

Chief Counsel attorneys must ensure that their actions

(or failure to act) preserve the sanctity of the court and

safeguard the public’s confidence in the judicial process.

Id.

- 68 The notice explained that Chief Counsel attorneys must

conduct their activities in accordance with the letter and spirit

of the Model Rules of Professional Conduct of the American Bar

Association (ABA Model Rules).

ABA Model Rules 4.1 and 8.4.

The notice specifically discussed

ABA Model Rule 4.1 provides in part

that in the course of representing a client, a lawyer shall not

knowingly make a false statement of material fact or law to a

third person, or fail to disclose a material fact when disclosure

is necessary to avoid assisting a criminal or fraudulent act by a

client, unless disclosure is prohibited under ABA Model Rule 1.6

regarding client-lawyer confidentiality.

It is also professional

misconduct under ABA Model Rule 8.4 for a lawyer to engage in

conduct involving dishonesty, fraud, deceit or misrepresentation

or to engage in conduct that is prejudicial to the administration

of justice.

The notice concluded:

“All Chief Counsel attorneys are

expected to carry out their responsibilities with the utmost

integrity.

Clearly, the conduct of the Chief Counsel attorneys

in Dixon fell far short of those high standards.”

CC-2003-008.

Determination on Remand of Terms of the Thompson

Settlement by Dixon VI and VIII

Our Dixon VI opinion responded to the directions of the

Dixon V opinion and primary mandate to determine how the Thompson

settlement would be imposed against respondent in favor of the

test case petitioners and all parties properly before the Court.

- 69 In Dixon VI, we held that: (1) The final Thompson settlement is

to be regarded as resulting in a 63.37-percent reduction of the

Thompsons’ deficiencies, as well as elimination of all

Kersting-related penalties and additions; (2) the Thompson

settlement encompasses and requires the vacating of the portion

or portions of the deficiencies determined against any Kersting

project petitioners that may be attributable to the “Bauspar”

shelter that was also promoted by Kersting; (3) the Thompson

settlement’s cancellation of the Thompsons’ 1981 late-filing

addition justifies cancellation of not only all

non-Kersting-related penalties and additions but also all other

substantive adjustments not arising from shelters promoted by

Kersting; (4) interest on the reduced deficiencies shall not be

charged beyond the date in June 1992 fixed by respondent’s

concession.29

Respondent conceded that the accrual of interest on

Kersting project deficiencies ultimately determined by this Court

should be tolled as of June 1992, in accordance with the Jan. 21,

2003 public announcement of then IRS Chief Counsel B. John

Williams. In a speech on that date at the annual meeting of the

New York State Bar Association Tax Section, Williams assured the

public that no interest would be charged on Kersting project

deficiencies for the period of the appeals. As indicated by

Dixon VI n.30: “The original decisions in Dixon II were entered

Mar. 13, 1992; the [original] notices of appeal were filed May

14, 1992; the 90-day appeal period would have expired June 11,

1992.” Stipulated decisions and decisions entered under Rule 155

following Dixon VI and VIII provide that “No interest shall

accrue [on deficiencies] during the period from May 14, 1992,

through the date that is 90 days after the decision in this case

is entered.” Motions are pending before the Tax Court in 16

cases of Kersting project nontest case petitioners with

(continued...)

- 70 Respondent and the Kersting project petitioners had agreed

in a stipulation of settled issues that the relief extended to

all docketed cases in the Kersting project remaining open,

whether or not the Kersting project petitioners had signed

piggyback agreements.30

In Dixon VIII we denied the motion of the Hongsermeier test

case petitioners for reconsideration of Dixon VI.

The

Hongermeiers alleged that respondent engaged in attempts at a

continued coverup of the fraud of respondent’s attorneys, and

they asked the Court to impose additional sanctions on respondent

for respondent’s alleged continued misconduct.31

The alleged

(...continued)

deficiencies, as of Sept. 13, 2007, in cases in which decisions

giving effect to the Thompson settlement have not yet been

entered, to stop further accrual of interest on their

deficiencies after Sept. 13, 2007.

Dixon VI, 91 T.C.M. (CCH) at 1107, 2006 T.C.M. (RIA) par.

2006-090, at 2006-671.

Kersting project petitioners who settled their cases and

have filed motions for leave to file motions to vacate (see Part

VIII infra) make similar allegations. They ask the Court to

conduct an evidentiary hearing to determine whether, following

the trial of the test cases, the conduct of respondent’s

management related to the posttrial settlement offer continued

the fraud on the Court (or constituted a new fraud on the Court)

and, if the Court so finds, to impose the Dixon V sanction on

respondent for that conduct. Another evidentiary hearing is

unnecessary because of our holding herein that the fraud

committed on the Court by respondent’s counsel during the test

case proceeding was a fraud on the Court in the case of every

Kersting project petitioner who was bound by the test cases and

that the Dixon V sanction is to be imposed against respondent in

each such case. We impose sanctions in all cases where decisions

(continued...)

- 71 misconduct of respondent’s managers following the trial of the

test cases was directly in issue in the prior proceedings before

this Court in the DuFrense remand and before the Court of Appeals

in the Dixon V appeal.

We therefore held that the issue of any

continuing misconduct was covered by necessary implication by the

opinion of the Court of Appeals in Dixon V and by its most recent

primary mandate.

In Dixon VIII, we concluded that the law of the

case and the primary mandate of the Court of Appeals in Dixon V

precluded us from conducting any further inquiry into

respondent’s misconduct and from imposing any additional sanction

on respondent with respect to cases of Kersting project

petitioners who were properly before the Court of Appeals.

The Hongsermeiers (represented by Minns) and Kersting

project petitioners in 12 other test and nontest cases

(represented by Izen and Sticht) have appealed to the Court of

Appeals for the Ninth Circuit our decisions giving effect to the

Thompson settlement sanctions as formulated in our Dixon VI and

VIII opinions.

In Dixon VII and Young v. Commissioner, T.C. Memo. 2006-189,

we responded to the Dixon V supplemental mandate with regard to

Kersting project petitioners’ appellate attorney’s fees and costs

incurred in Dixon V.

We have determined that both test case and

(...continued)

were entered on or after June 10, 1985, the date the Court agreed

to use the test case procedure in the Kersting project cases.

- 72 nontest case Kersting project petitioners represented by various

counsel are entitled to appellate attorney’s fees and have

determined the amounts of those fees.

The Court now has under consideration various Kersting

project petitioners’ applications for post Dixon V attorney’s

fees and costs incurred in the Dixon V remand proceedings.

VIII.

Motions To Vacate

In 71 of the more than 500 Kersting-related nontest cases in

which stipulated decisions were entered both before and after

respondent’s discovery and disclosure to the Court of McWade’s

and Sims’s misconduct, Kersting project petitioners have filed

motions for leave to file motions to vacate the decisions.

Petitioners and the other Kersting project petitioners filing or

attempting32 to file such motions seek new decisions reflecting

the benefits of the Thompson settlement as mandated by the Court

of Appeals in Dixon V.

The Lewises, in their motions, ask us to

vacate their stipulated decisions so they can “participate in the

benefits to be generated by the subsequent proceedings mandated

by the Court of Appeals in Dixon V”.

In Lewis v. Commissioner,

T.C. Memo. 2005-205, we denied the Lewises’ motions for leave to

file motions to vacate stipulated decisions.

In Lewis, we focused on the legal consequences of the

Lewises’ acceptance of respondent’s posttrial settlement offer,

The Court has returned unfiled numerous other such motions

because of procedural defects.

- 73 applying general principles of contract law.

We found that the

Lewises, who settled after respondent disclosed the secret

settlements to the Court, abandoned any opportunity to benefit

from the mandate of the Court of Appeals in Dixon V, issued 10

years after respondent’s posttrial settlement offer.

We found

that knowledge of the Lewises and their counsel of the secret

settlements and allegations of fraud on the Court made in the

appeals of Dixon II filed in the Court of Appeals for the Ninth

Circuit precluded a claim of fraud and that, by settling as they

did, the Lewises assumed the risk that, as a result of the thenpending appeals, other Kersting project petitioners might become

entitled to a more favorable outcome.

The Lewises timely filed motions for reconsideration.

now believe that we applied the wrong law in Lewis, as the Court

of Appeals in Dixon V held we did in Dixon III and IV, and that

we failed to appreciate and apply the full scope of the holding

of Dixon V in accordance with its rationale.

We have therefore

granted the Lewises’ motions for reconsideration, granted the

motions for leave in the Lewis, Hartman, and Liu cases, and

consolidated them for the purpose of this opinion, in which we

hold that the underlying motions to vacate should be granted.

- 74 Discussion

Preliminary Comments

Respondent, Kersting project petitioners, the opinion-

reading public, and the Court of Appeals for the Ninth Circuit

might well consider this opinion a surprising about-face from our

opinion in Lewis v. Commissioner, supra.

We therefore indicate

some of the considerations that have led to our change of

position.

Hartman’s and the Lius’ motions for leave to vacate and the

Lewises’ motions for reconsideration led us to reread the Dixon V

opinion.

Our rereading prompted us to compare the different

situations of the 400-500 settling Kersting project petitioners,

who at various times were induced to agree to entry of stipulated

decisions, with the situations of the more than 1,300 nonsettling

petitioners who have delayed entry of decisions in their cases

through the appeal process in the Court of Appeals for the Ninth

Circuit.33

These more than 1,300 Kersting project petitioners have

sorted into three groups: (1) Those who, after issuance of our

opinions in Dixon VI and VIII responding to the mandate of Dixon

V to determine and apply the Thompson settlement to the Kersting

project cases, have agreed to entry of stipulated decisions in

accordance with our opinions in Dixon VI and VIII and waived

their appeal rights; (2) those who have had decisions entered in

accordance with the terms of the Thompson settlement as

determined by our opinions in Dixon VI and VIII, and have filed

appeals to the Court of Appeals for the Ninth Circuit; and (3)

those who continue to await the final outcome of those test cases

that have been appealed to the Court of Appeals for the Ninth

Circuit. We assume that all Kersting project test cases and

(continued...)

- 75 The observation of the Court of Appeals in Dixon V that the

misconduct of respondent’s attorneys violated the rights of all

petitioner participants in the Kersting project to a fair trial

of the test cases brought home to us more keenly than we had

previously appreciated that our Lewis opinion would result in

disparate treatment of those who have agreed to entry of

stipulated decisions at various times along the way, as compared

with those who have awaited the final outcome.

We had a visceral

reaction that our Lewis opinion violated some sense of

distributive justice,34 whether derived from notions of equality35

or of fairness,36 and that the Dixon V opinion and mandate

required a contrary result.

Recognizing the incompatibility of

the various formulations of distributive justice by political

philosophers over the years,37 we mention those formulations as no

(...continued)

nontest cases on appeal to the Court of Appeals for the Ninth

Circuit will be reviewed by the panel that issued the opinion in

Dixon V. See supra note 5 and accompanying text.

See Aristotle, “Nichomachean Ethics”, bk. V, chs. 2 and 3,

Introduction to Aristotle (Richard McKeon, ed., Modern Library

1947). Aristotle’s original formulation of distributive justice

in terms of the relative merits or virtuousness of the

individuals among whom goods are to be apportioned might be

deemed to be more in line with our opinion in Lewis, than the

more recent formulations mentioned infra notes 35 and 36.

See Hobbes, Leviathan (1651), ch. xv, at 208 (Pelican

Classics 1968).

See Rawls, A Theory of Justice (rev. ed. 1999).

See MacIntyre, After Virtue, 246-257 (2d ed. 1984).

- 76 more than intimations that we should reconsider our Lewis

position in the light of our rereading of the Dixon V opinion.

Those intimations have led us to reflect on the various

situations of those Kersting project petitioners who were part of

the test case proceedings and who agreed to entry of stipulated

decisions at different times along the way after the test case

proceedings began.38

First, there are Kersting project petitioners who settled

with respondent before the misconduct had begun or who, like

Hartman, settled after the misconduct had begun but before the

Court issued Dixon II and before respondent’s management

discovered the misconduct and disclosed it to the Court.

Such

petitioners, irrespective of whether they had concluded that

their position on the merits was well-nigh hopeless or had some

chance of success, were entitled to assume that the test cases

whose outcome would determine the tax effects of the Kersting

programs would be well and fairly tried.

That assumption was

defeated by McWade’s and Sims’s intervening misconduct.

Second, there is a small group of Kersting project

petitioners who agreed to entry of stipulated decisions during

what respondent calls the “gap period”, after the Court issued

Any Kersting project taxpayers who settled with respondent

before the Court agreed to use the test case procedure in

resolving the bulk of the Kersting project cases were not part of

the test case proceedings. Those taxpayers were not affected by

the fraud on the Court, and sanctions are not warranted in their

cases.

- 77 Dixon II and before respondent’s management discovered the

misconduct and disclosed it to the Court.

Respondent has

conceded that Kersting project petitioners in this category are

entitled to have their stipulated decisions vacated so they can

avail themselves of the benefits of the Thompson settlement.39

Third, there were Kersting project petitioners, such as the

Lius and the Lewises, who accepted the reinstated project

settlement offer after respondent had disclosed the misconduct to

the Court, and who, actually or through counsel, had or may have

become aware of the Cravens and Thompson settlements and of the

pending appeals.

However, they may well have been discouraged by

the Court’s denial of respondent’s motion for an evidentiary

hearing and his conclusion that the misconduct had not affected

the outcome of the test cases.

They may have been disheartened

Respondent has made this concession on the record in Kahle

v. Commissioner, docket Nos. 24558-84 and 38976-84, cases in

which stipulated decisions conceding respondent’s adjustments in

full were entered in the “gap period” with respect to which

petitioner has filed motions for leave to file motions to vacate.

On Oct. 2, 1991, Terrence Kahle (Kahle), proceeding pro se,

contacted McWade conceding the Kersting issues and requesting

that McWade send decision documents. McWade sent decision

documents to Kahle on Oct. 9, 1991, and Kahle signed them on Dec.

20, 1991, 9 days after the Court published Dixon II. The

decisions in Kahle’s cases were entered on Jan. 6, 1992, and

became final before respondent discovered the misconduct of

McWade and Sims and disclosed it to the Court. On Feb. 24, 1994,

respondent administratively abated Kahle’s deficiencies and

additions and attempted to give him the benefit of the 7-percent

reduction of the posttrial settlement offer. Respondent has

conceded that the stipulated decisions entered in Kahle’s cases

and any other stipulated decisions entered during the gap period

should be vacated and new decisions entered in accordance with

Dixon VI.

- 78 by the Court’s apparent failure to appreciate or consider that

McWade’s and Sims’s conduct was unethical and fraudulent and

puzzled by respondent’s failure to appeal the Thompson and

Cravens decisions.

Again, they were probably further discouraged

by our denials of the timely motions to intervene filed in the

Thompson and Cravens cases by Attorneys Sticht and Izen on behalf

of their nontest case petitioner clients.

These developments were soon followed by respondent’s

reinstatement of the lowball nuisance value project settlement

offer, an offer that intentionally did not disclose that it was

much less favorable to Kersting project petitioners than the

final secret Thompson settlement and failed to disclose and

acknowledge to the public that the settlement and its having been

kept secret were improper, much less admit the dimensions and

seriousness of the intervening misconduct.

Although the offer

stated that the Court had decided that the settlements did not

change the results in Dixon II, it failed to acknowledge that

Dixon II was being appealed.

The offer also failed to

acknowledge that allowing the Thompsons a settlement that

provided them more favorable treatment than other taxpayers and

compensating the Thompsons for their attorney’s fees violated IRS

policy and the Department of the Treasury Minimum Standards of

Conduct.

While the offer claimed it was being made in fairness

to Kersting project petitioners, acceptance of the offer

continued and confirmed the disparate treatment of the accepting

- 79 petitioners in comparison to both the Thompsons and the Chicoine

and Hallett and DeCastro clients who had obtained 20-percent

reduction settlements.

The reinstated offer was merely an attempt at damage

control; it did not purge the fraud that besmirched every case

that was part of the Kersting project test case proceedings; it

did not mitigate the harm caused by that fraud.

The offer left

the Lius, the Lewises, and more than 400 other Kersting project

petitioners with the overwhelming impression that, realistically

speaking, respondent’s lowball nuisance value reinstated project

settlement offer was the only game in town, and that it was

generous because in all likelihood the adverse decisions against

the test case petitioners would be sustained on appeal.40

This impression was confirmed by the opinion of the Court of

Appeals on the first appeal in DuFresne v. Commissioner, 26 F.3d

105 (9th Cir. 1994), which seemed to ignore the fraud on the

court arguments made to it by Attorney Izen--even as it remanded

for an evidentiary hearing to determine the extent of the

Our pejorative characterization of respondent’s

reinstatement of the project settlement offer following the

misconduct of respondent’s attorneys in the Kersting test cases

should not be seen as the Court’s view of the Commissioner’s use

of such an offer to settle cases in other tax shelter projects

where, in the Commissioner’s view, the shelter lacks merit. It

is not the province of the courts to second-guess the

Commissioner’s exercise of professional judgment in doing his

job. See United States v. Payner, 447 U.S. 727, 737 (1980)

(Burger, C.J., concurring) (Supreme Court has no general

supervisory authority over executive branch operations).

- 80 misconduct--by couching the analysis in terms of structural

defect versus harmless error.

The same panel, in its unpublished

opinion in Adair v. Commissioner, 26 F.3d 129 (9th Cir. 1994),

affirming our denial of Sticht’s and Izen’s motions for

intervention in the Thompson and Cravens cases, appeared to

ignore the possibility of fraud on the court when it held that

the Thompson and Cravens decisions had become final; this would

not have been so had the panel recognized that the misconduct

might have been a fraud on the court.

Commissioner, 441 F.2d at 934.

See Toscano v.

In the same vein, our opinions in

Dixon III and IV responded to the mandate of DuFresne by applying

traditional harmless error analysis to hold that the misconduct

of respondent’s attorneys did not entitle the test case

petitioners (and, by extension, all Kersting project petitioners)

to any substantial relief other than remission of additions and

awards of attorney’s fees.

Dixon V held that our focus on

harmless error analysis was wrong at every turn.

The foregoing observations have also led us to consider the

career of Justice Holmes’s famous dictum:

“Men must turn square

corners when they deal with the Government.”

Rock Island, Ark. &

La. R.R. Co. v. United States, 254 U.S. 141, 143 (1920).

The

phrase originated in a tax refund case holding that taxpayers

must comply with even formal statutory conditions to the

Government’s consent to be sued; its subsequent invocations have

led to judicial recognition of the correlative proposition that

- 81 Government officials have some minimum substantive obligations to

the citizens they have been hired to serve.

Even as the Supreme

Court continued strictly to limit claims of estoppel against the

Government, it recognized that citizens have an interest in “some

minimum standard of decency, honor, and reliability in their

dealings with their Government”, see Heckler v. Comty. Health

Servs., Inc., 467 U.S. 51, 61 (1984); that “when the Government

acts in misleading ways, it may not enforce the law if to do so

would harm a private party as a result of governmental

deception”, id. n.12 (citing United States v. Pa. Indus. Chem.

Corp., 411 U.S. 655, 670-675 (1973), and Moser v. United States,

341 U.S. 41 (1951)); and that “‘Men naturally trust in their

government, and ought to do so, and they ought not to suffer for

it’”, id. n.13 (quoting Menges v. Dentler, 33 Pa. 495, 500

(1859)).

These usages were preceded by observations in dissent

that “there is no reason why the square corners should constitute

a one-way street”, FCIC v. Merrill, 332 U.S. 380, 387-388 (1947)

(Jackson, J., dissenting), and “It is no less good morals and

good law that the Government should turn square corners in

dealing with the people than that the people should turn square

corners in dealing with their Government”, St. Regis Paper Co. v.

United States, 368 U.S. 208, 229 (1961) (Black, J., dissenting),

that have more recently been quoted in support of deciding a

claim against the Government, see United States v. Winstar Corp.,

518 U.S. 839, 886 n.31 (1996);