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RD00RDED
SERVICE
| CAL.
STAT.
S.2. JUDGE
T.C. Memo. 2006-90
042
UNITED STATES TAX COURT
JERRY AND PATRICIA A. DIXON, ET AL.,1 Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos.
9382-83,
17642-83,
10588-83,
17646-83,
Filed May 2, 2006.
¹Cases of the following petitioners have been treated as
cases related to the above-captioned case for purposes of the
additional evidentiary hearing required to give effect to the
mandates of the Court of Appeals for the Ninth Circuit in Dixon
v. Commissioner, 316 F.3d 1041, 1047 (9th Cir. 2003), as amended
Mar. 18, 2003 (Dixon V), revg. and remanding T.C. Memo. 1999-101
042
(Dixon III).:
Robert H. and Barbara A. Gridley, docket Nos.
10588-83, 10931-84, 38757-84; Norman W. and Barbara L. Adair,
docket Nos. 17642-83, 38965-84, 35608-86, 479-89, 8070-90; Ronald
L. and Matt.ie L. Alverson, docket No. 17646-83; Russell L. Fleer,
Sr. and Sally A. Fleer, dócket Nos. 27053-83 and 13477-87; Hoyt
W..and Barbara D. Young, docket Nos. 4201-84, 22783-85, 30010-85;
Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84,
30979-85; John L. and Terry E. Huber, docket No. 20119-84; Arden
L. and Barbara G. Blaylock, docket No. 28723-84; Terry D. and
Gloria K. Owens, docket No. 40159-84; Richard and Fiorella
Hongsermeier, docket No. 29643-86; Willis F. McComas, II and
Marie D. McComas, docket No. 19464-92; Wesley Armand and Sherry
Lynn Cacia Baughman, docket No. 621-94; Joe A. and JoAnne
Rinaldi, docket No. 7205-94; Norman A. and Irene Cerasoli, docket
No. 9532-94; Stanley C. and Sharon A. Titcomb, docket No. 1799295; Richard B. and Donna G. Rogers, docket No. 17993-95. The 27
related cases have been consolidated for briefing and opinion. .
SEFIVED MAY_ 2 2006
- 2 27053-83,
10931-84,
20119-84,
38757-84,
40159-84,
30010-85,
29643-86,
13477-87,
8070-90,
621-94,
9532-94,
17993-95.
4201-84,
15907-84,
28723-84,
38965-84,
22783-85,
30979-85,
35608-86,
479-89,
19464-92,
7205-94,
17992-95,
In Dixon v. Commissioner, 316 F.3d 1041 (9th Cir.
2003), revg. and remanding T.C. Memo.. 1999-101, the
Court of Appeals held that the misconduct of R's trial
attorney and his supervisor in the trial of the test
cases for the Kersting tax shelter project, in agreeing
with counsel for T, one of the test case Ps, to a
secret settlement of T's deficiencies (not disclosed to
IRS management, to this Court, or to counsel for other
test case Ps), was a fraud on the Court.
The Court of
Appeals ordered this Court to sanction R by entering
judgment in favor of the remaining test case Ps and
other Ps in the Kersting tax shelter group before the
Court on "terms equivalent to those provided in the
[final] settlement agreement with [T] and the IRS",
leaving to this 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 in the [T] settlement".
R argues that the substance of the T settlement
was a 20-percent reduction of T's 1979-1981
deficiencies, plus the payment of T's attorney's fees.
Ps argue that the T settlement was, in form and
substance, a 62.17-percent reduction of T's 1979-1981
deficiencies, plus other benefits that bring the T
settlement to a 79.92-percent reduction in the
deficiencies. The parties agree that the T settlement
also included cancellation of all additions and
penalties, including nonshelter-related additions and
penalties, and the use of a "burnout" to reduce the
accrual of interest on the remaining deficiencies.
Ps
argue that interest on the deficiencies should not be
charged beyond Dec. 31, 1986, which, in their view,
marks the inception of the fraud on the court. R has
conceded that no interest will be charged on the
deficiencies for the period of the appeals to the Ninth
Circuit commencing in 1992.
Held: The final settlement of T's 1979-1981
deficiencies amounts to a 62.17-percent reduction of
those deficiencies.
Held, further: Two minor additional benefits
included in.the T settlement bring the reduction
percentage up to 63.37 percent.
Held, further: The T settlement encompasses and
requires the vacating of the portion or portions of the
deficiencies determined against any Ps that may be
attributable to the "Bauspar" shelter that was also
promoted by Kersting and to any other issues not
.arising from shelters promoted by Kersting.
Held, further:
Interest on the reduced
deficiencies shall not be charged beyond the date in
1992 fixed by R's concession and shall not be stopped.
as of any earlier date.
Henry G. Binder and John A.
Irvine,
for petitioners
, in docket Nos. 9382-83, 15907-84, and 30979-85.
Joe Alfred Izen, Jr., for petitioners in docket Nos.
17642-83, 4201-84, 38965-84, 40159-84, 22783-85, 30010-85,
35608-86, 479-89, and 8070-90.
Robert Alan Jones, for petitioners in docket Nos. 17646-83,
10931-84, 38757-84, 19464-92, 621-94, and 9532-94.
Declan J. O'Donnell, for petitioners in docket Nos.
10588-83, 27053-83, 28723-84, and 13477-87.
- 4 Michael Louis Minns and Enid M. Williams, for petitioners in
docket No. 29643-86.
Robert Patrick Sticht and Boris Orlov, for petitioners in
docket No. 7205-94.
.
Robert Patrick Sticht,
for petitioners in docket Nos.
20119-84, 17992-95, and 17993-95.
Henry E. O'Neill and Peter R. Hochman, for respondent.
CONTENTS
Page
FINDINGS OF FACT . . . . . . . . . . . . . .
I. The Kersting Tax Shelters . . . . . . .
A. Background . . . . . . . . . . . .
B.
Respondent's Kersting Project . . .
1. In General . . . . . . . . . .
2. Bauspar . . . . . . . . . . .
C.
II.
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11
12
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13
13
14
Respondent's Project Settlement Offer
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15
. . . . . . . . . . . . . . . . . . .
16
.
The Thompsons' Participation in the Kersting
Tax Shelters
A.
The Thompsons' Tax Returns . . . . . .
1.
Prepetition Years--1977 .and 1978 .
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16
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18
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Examination of the Thompsons' 1978-1981 Returns .
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19
III. The Test Case Litigation and the Thompson Settlements
A.
Selection of the Test Cases . . . . . . . . . . .
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22
22
2.
042
3.
B.
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Years Before the Court . . . . . . . . . .
1979 . . . . . . . . . . . . . . . . . . .
1980 . . . . . . . . . . . . . . . . . . .
1981 . . . . . . . . . . . . . . . . . . .
Years Following Those Before the Court . .
1982 . . . . . . . . . . . . . . . . . . .
1983 . . . . . . . . . . . . . . . . . . .
1984 . . . . . . . . . . . . . . . . . . .
1985 . . . . . . . . . . .- . . . . . . . .
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16
16
- 5 B.
C.
D.
E.
F.
Deterioration of the Thompson-Kersting
Relationship
. . . . . . . . . . . . . . . . . . .
The Thompsons Engage DeCastro, Who Settles
23
Their Cases . . . . . . . . . . . . . . . . . . . .
IRS Activity Regarding the Thompsons'
1983-85 Returns . . . . . . . . . . . . . . . . . .
25
30
The Reporting and Resolution of the Thompsons'
Deficiency Interest Payments for 1986 and 1987
The Thompson Settlement Revised as Trial
.
.
33
Approaches . . . . . . ... . . . . . . .
Trial and Entry of Decisions . . . . . .
Discovery and Disclosure of the Thompson
Settlements . . . . . . . . . . . . . . .
Implementation and Effects of the
Final Thompson Settlement . . . . . . . .
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35
38
42
52
Respondent's Disciplinary Action
Against Sims and McWade . . . . .
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57
Ninth Circuit Remand and Subsequent Proceedings
A.
Ninth Circuit Orders in the DuFresne Case .
B.
Evidentiary Hearing and Opinions
After the Remand in DuFresne
. . . . . . .
C.
The Ninth Circuit's Opinion and
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58
58
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60
Mandates in These Cases . . . . . . . . . . . . . .
64
D.
E.
Proceedings Following Remand . .
Further Disciplinary Proceedings
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67
68
OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . .
Preliminary Comments . . . . . . . . . . . . . . . . . . . .
70
70
G.
H.
I.
J.
IV.
042
I.
Procedural Issues Following Remand .
A.
B.
C.
D.
II.
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77
Procedural Posture . . . . . . . . . . . . . . . .
Law of the Case . . . . . . . . . . . . . . . . .
Parties Before the Court
. . . . . . . . . . . . .
Burden of Proof . . . . . . . . . . . . . . . . . .
Defining and Applying the Thompson Settlement
78
79
80
81
A.
B.
Overview . . . . . . . . . . . . . . . . . . . . .
Areas of Agreement . . . . . . . . . . . . . . . .
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84
C.
Starting Point:
The Thompsons' .Settlement
of Proposed Deficiencies for 1979-1981
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1.
Respondent's Position . . . . . . . .
2.
Petitioners' Position . . . . . . . .
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88
88
90
D.
3. Analysis . . . . . . . . . . . . . . . . . . .
1981 Tax Year . . . . . . . . . . . . . . . . . . .
Other Benefits Relating to the Thompsons'
84
86
91
99
.
- 6 1.
2.
Elimination of the Thompsons' Late
Filing (Non-Kersting) Addition for 1.981
.
Respondent's Failure To Address the
Bauspar Issue in the Thompsons' Statutory
Notice for 1981
E.
.
. . . . . . . . . . . . . .
.
99
. 100
Benefits to the Thompsons Relating to Years
Other Than 1979-1981 . . . . . . . . . . . . . . . 100
1.
In General . . . . . . . . . . . . . . . . .
2.
The Thompsons' Escape From Kersting
Liability with Respe.ct to 1982 . . . . .
The Thompsons' 1983 Kersting Deficiency
and the Disappearing Statutory Notice .
The Thompsons' 1983-85 Bauspar .
3.
4.
5.
6.
Deductions
. 100
.
.
. 102
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.
. 108
. . . . . . . . . . . . . . . .
. 109
The Thompsons' Deduction of Prepaid
Interest on Their 1986 and 1987 Returns
.
.
1986 . . . . . . . . . . . . . . . . . . . .
1987 . . . . . . . . . . . . . . . . . . . .
The Thompsons' Attorney's Fee
Deduction for 1993 . . . . . . . . . . . . .
. 117
7.
F.
G.
The Thompsons' Failure To Report
Tax Benefit Income for 1993
. . . . . . .
8.
Payment of Witness Fees to Mr. Thompson
.
9.
Release of Lien on the Thompsons'
Property and Other Intangible Benefits . .
The Percentage Reduction Summarized . . . . . .
. 111
. 111
. 115
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. 119
. 122
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Additional Relief . . . . . . . . . . . . . . . .
1.
2.
3.
4.
Elimination of Non-Kersting Additions
. .
Allowance of Bauspar Deductions . . . . .
Elimination of Non-Kersting Deficiencies .
Attorney's Fees
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. . . . . . . . . . . . . .
III. Interest on Deficiencies and Overpayments
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123
125
126
126
. 127
. 127
.. 128
. 129
- 7 MEMORANDUM FINDINGS OF FACT AND OPINION2
BEGHE, Judge:
With this opinion, .the Court hopes to provide
a template for resolution of the more than 1,3003 remaining cases
2This opinion is issued pursuant to the mandates of the
Court of Appeals for the Ninth Circuit in Dixon V, revg. and
remanding Dixon III.
Dixon III had supplemented our Memorandum
Findings of Fact and Opinion in Dixon v. Commissioner, T.C. Memo.
1991-614 (Dixon II), vacated and.remanded per curiam sub nom.
DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994).
For the
record, Dixon I is reported as Dixon v. Commissioner, 90 T.C. 237
(1988), holding that petitioners had failed to establish standing
to contest a search of Kersting's office, thereby sustaining the
validity of the deficiency notices generated by the information
discovered in that search.
Dixon IV, reported as Dixon v.
Commissioner, T.C. Memo. 2000-116, provided for awards of
attorney's fees under sec. 6673(a)(2) to petitioners in Dixon
III.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
042
all Rule references are to the Tax Court Rules of Practice and
Procedure.
3In addition to the more than 1,300 open cases, petitioners
in 52 of the more than 500 other dockets in the Kersting project
in which stipulated decisions were entered, both before and. after
discovery and disclosure of the misconduct held by·the Court of
Appeals in Dixon V to have constituted fraud on the Court, have
filed motions for leave to file motions to vacate. their
decisions.
The Court has returned unfiled numerous other such
motions because of procedural defects.
Petitioners filing or
attempting to file such motions have thereby sought to become
entitled to the benefits of the Thompson settlement as mandated
by the Court of Appeals in Dixon V. Motions for reconsideration
have been filed in the three dockets addressed in Lewis v.
Commissioner, T.C. Memo. 2005-205, in which we denied
petitioners' motions for leave to file motions to vacate
stipul.ated decisions in Kersting-related cases.
- 8 of petitioner participants in the second generation4 of tax
shelter programs (the Kersting project) promoted by Henry F.K.
Kersting (Kersting).5
During the trial on the merits of the test
cases used to try to resolve the vast majority of the pending
cases in the Kersting project,6 respondent's trial counsel
Kenneth W. McWade (McWade)
(with the knowledge and connivance of
4In Pike v. Commissioner, 78 T.C. 822 (1982), affd. without
published opinion 732 F.2d 164 (9th Cir. 1984), this Court
sustained respondent's disallowance of all deductions for
interest, losses, and credits claimed by participants in
Kersting's first-generation programs.
SFor additional information about the Kersting project, see
infra Parts I.A. and I.B.
Before his death on Mar. 4, 2000,
Kersting and the tax shelter programs he promoted were frequently
before the courts.
In addition to those cases cited supra notes
2, 3, and 4, see also, e.g., United States v. Kersting, 891 F.2d
1407 (9th Cir. 1989) (holding that an IRS summons was enforceable
against some Kersting program participants); Richards v.
Commissioner, T.C. Memo. 1997-149, Supplemental Opinion T.C.
Memo. 1997-299 (upholding Kersting project deficiency notice),
affd. without published opinion 165 F.3d 917 (9th Cir. 1998);
Gridley v. Commissioner, T.C. Memo. 1997-210 (denying
petitioners' motions for summary judgment to obtain benefit of
Thompson settlement); Kersting v. United States, 206 F.3d 817
(9th Cir. 2000) (promoter penalties upheld); Kersting v.
Commissioner, T.C. Memo. 1999-197 (sustaining deficiencies
against Kersting personally); United States v. Kersting, 77 AFTR
96-1717 (Bankr. D. Haw. 1996) (denying Kersting bankruptcy
discharge).
61n 1986, counsel for the parties in the Kersting-related
cases agreed. to a test case procedure, under which a few typical
cases are selected as test cases, while the petitioners whose
cases are not selected as test cases are encouraged to execute a
"piggyback" agreement, i.e., a stipulation to be bound by the
outcome of the test cases.
The majority of petitioners in the
Kersting-related cases executed piggyback agreements.
See the
discussion in Gridley v. Commissioner, supra note 5.
_ g _
his supervisor, Honolulu District Counsel William A. Sims
(Sims)), entered into secret settlements with Luis DeCastro
(DeCastro), counsel for test case petitioners John R. and Maydee
Thompson (the Thompsons).
The financial terms of the final
settlement were much more advantageous to the Thompsons than the
settlements generally made available to other petitioner
participants in the Kersting project.'
The final settlement with
the Thompsons was intended to provide refunds of tax and interest
paid by the Thompsons under a prior settlement, plus interest
thereon, that were to be used--and the bulk of the refunds was
used--to pay DeCastro's fees for providing the appearance of his
independent representation of the Thompsons at the trial of the
test cases.
After this Court upheld respondent's determinations
and entered decisions in favor of respondent in all the test
cases, see Dixon v. Commissioner, T.C. Memo. 1991-614
(Dixon II),
respondent's senior management discovered the settlements, moved
this Court to vacate the decisions (including the decisions in
the Thompsons' cases) that had not already been appealed to the
70ne nontest case petitioner, Denis Alexander, in exchange
for his acting as a witness and serving as an undeclared .
consultant to McWade dùring.the original trial of the test cases,
as described in Dixon III at Findings of Fact V.B. and VI.F.,
received a settlement even more favorable than that afforded the
Thompsons. Although the Court of Appeals in Dixon V noted
Alexander's settlement, the Court of Appeals did not rely on or
refer to that settlement in formulating the sanction to be
imposed by its mandates.
- 10 Court of Appeals for the Ninth Circuit, and requested an
evidentiary hearing.
After vacating the decisions, the Court
denied the motion for evidentiary hearing, entered decisions for
the Thompsons in accordance with their final settlement, and
reentered or allowed to stand its decisions in the other test
cases.
The Court thereafter denied motions by test case and
nontest case petitioners to intervene in the Thompsons' cases
shortly before the new decisions in those cases became final.
DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994)
In
(hereafter
DuFresne), the Court of Appeals for the Ninth Circuit vacated the
decisions against the other test case petitioners on the ground
that the misconduct of Sims and McWade required further inquiry.
The Court of Appeals directed this Court to hold an evidentiary
hearing to determine:
"whëther the extent of misconduct rises to
the level of a structural defect voiding the judgment as
fundamentally unfair, or whether, despite the government's
misconduct, the judgment can be upheld as harmless error."
Id.
at 108.
This Court conducted the evidentiary hearing directed by the
Court of Appeals and held that the misconduct of the Government
. attorneys did not create a structural defect but rather resulted
in harmless error.
101 (Dixon III).
See Dixon v. Commissioner,
T.C. Memo. 1999-
We imposed sanctions against respondent in the
form of.relief from the accrual of interest on additions to tax
- 11 for negligence as well as relief from additional interest under
section 6621(d)/(c)
(hereafter, section 6621(c)).8
The other test case petitioners again appealed.
The Court
of Appeals for the Ninth Circuit reversed and remanded our
decisions in those test cases in Dixon v. Commissioner, 316 F.3d
1041 (.9th Cir. 2003), as amended on March 18, 2003 (Dixon V).
The Court of Appeals held that the misconduct of respondent's
counsel constituted a fraud on the court and directed this Court
to enter decisions "in favor of Appellants and all other
taxpayers properly before this Court on terms equivalent to those
provided in the settlement agreement with Thompson and the IRS."
Id. at 1047.
In this opinion, we determine. the terms of the
Thompson settlement and their application to the Kersting project
participants before the Court.
FINDINGS OF FACT
The parties have filed a stipulation of facts for
evidentiary hearing on September 20, 2004; a first supplemental
stipulation of facts for evidentiary hearing on September 20,
2004; a second supplemental stipulation of facts for evidentiary
hearing on November 22, 2004; a third supplemental stipulation of
"Sec. 6621(d) was redesignated sec. 6621(c) by the Tax
Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 1511(c)(1)(A)-(C),
100 Stat. 2744, and repealed by sec. 7721(b) of the Omnibus
Budget Reconciliation Act of 1989, Pub. L. 101-239, 103 Stat.
2399.
- 12 facts for evidentiary hearing on March 29, 2005; a fourth
supplemental stipulation of facts, filed on June 17, 2005, and a
stipulation of settled issues, filed on June 22, 2005.
stipulated therein are so found.
The facts
The stipulation of facts and
the attached exhibits are incorp.orated herein by thìs reference.
The parties have further stipulated that, for purposes of the
present opinion, the Court may incorporate its findings of fact
as stated in earlier proceedings unless such facts are
inconsistent with the opinion of the Court of Appeals in Dixon V
or are inconsistent with facts stipulated or proven in
proceedings held after the issuance of Dixon V.
I.
The Kersting Tax Shelters
A.
Background
All the cases before the Court concern proposed
deficiencies, additions to tax, and interest that related to
petitioners' participation in tax shelter programs promoted by
Kersting.
All the programs involved both "primary" loans and
notes and "leverage" loans and notes with corporations organized
by Kersting that have been held to be his alter egos.
Kersting v. Commissioner, T.C. Memo. 1999-197.
See
These notes
sometimes bore dates that were long before the date on which the
documents were actually executed and even before the date on
which the participant informed Kersting he was ready to
participate in a particular program.
Kersting advised
- 13 participants in his programs that the programs created legitimate
investments that would entitle participants to interest
deductions that they should claim on their individual tax
returns.
B..
Respondent's Kersting Proiect
1.
In General
Kersting's promotion of his tax shelter programs had
attracted the attention of the Internal Revenue Service (IRS),
which instituted a tax shelter project known as the Kersting
project.9
In furtherance of that project, respondent sent
deficiency notices to more than 1,800 taxpayers who had
participated in the Kersting programs.
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 from the
District Counsel's Office.
In the Kersting project, McWade, from
9Tax shelter projects were initiated to deal with the large
volume of cases generated by tax shelter examinations during the
late 1970s and the early 1980s. Among the responses of the IRS
and the Tax Court were the development of procedures, including
tax shelter projects, 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, created the Tax Shelter Branch in the National
Office to.oversee tax shelter litigation across the country and
to organize individual tax shelter projects.
The projects
generally focused upon a spescific type of tax shelter, such as
those promoted by Kersting that constituted the Kersting project.
- 14 the Honolulu District Counsel's Office, served as the project
attorney.
Once a tax shelter project is assigned to a particular
District Counsel's Office, that District Counsel has the
authority to settle any individual case in the project.
The
District Counsel generally is expected to adhere to the official
project settlement offer.
Nevertheless, the District Counsel has
the authority in special circumstances to settle individual tax
shelter project cases on a basis different from the project
settlement offer.
2.
Bauspar
One Kersting program that was not part of respondent's
Kersting project was known as Bauspar.
Kersting had promoted the
Bauspar program as a combination savings and low interest
mortgage plan.
While the precise manner in which the Bauspar
program operated for each participant remains uncertain, the
total amount of home mortgage interest deducted by Bauspar
participants appears to have been overstated.
Respondent's officials believed that there were relatively
few participants in the Bauspar program, that there was no easy
way to identify participants in the Bauspar program from a review
of their income tax returns, and that an investigation of Bauspar
deduction claimants would not be cost effective.
Accordingly,
respondent ultimately decided not to systematically pursue
- 15 Bauspar participants through the Kersting project.
Respondent's
identification of Bauspar participants appears instead to have
been a "hit or miss" proposition; although respondent has
disallowed some Bauspar deductions claimed by a few Kersting
project petitioners, those disallowances have been sporadic.
Because the Bauspar program was not included in respondent's
Kersting project, we refer to interest deductions claimed under
the Bauspar program as Bauspar deductions rather than Kersting
deductions.
C.
.Respondent's Proiect Settlement Offer
Between 1982 and 1988, respondent had in effect an official
settlement offer for the Kersting project.
In general, the offer
permitted participants in the Kersting programs to resolve their
cases by agreeing to pay income tax deficiencies that averaged 7
percent less .than those determined in their deficiency notices.
The offer also released participants from negligence additions
and increased interest.
By September 1986, respondent's counsel had agreed to modify
the 7-percent reduction settlement offer to incorporate a new
feature, called the "burnout", that would apply in cases
involving more than oné taxable year.
Under this procedure, the
interest on a taxpayer's total unpaid deficiencies for. the first
and second years of tax liability would not begin to accrue until
the return due date for the second year.
The burnout thus
- 16 postponed for a year the accrual of interest on the first year's
deficiency, thereby reducing the total interest that accrued on
the deficiencies.
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.
II.
The Thompsons' Participation in the Kersting
Tax Shelters
A.
The Thompsons' Tax Returns
1.
Prepetition Years--1977 and 1978
Although the Thompsons participated in one of Kersting's
programs during 1977,
they did not clafm any Kersting-related
interest deductions on their income tax return for that year,
because their accountant refused to claim those deductions on the
return.
The record suggests the Thompsons first claimed Kersting
deductions on their 1978 tax return, which was prepared by an
accountant recommended by Kersting.
2.
Years Before the Court
1979
The Thompsons filed their 1979 tax return, pursuant to an
extension, on May 29, 1980.
The Thompsons reported Kersting
deductions of $39,477 on that return.
- 17 1980
The Thompsons received an extension of time to file their
1980 tax return until June 15,
1981.
On that return (received by
the IRS on June 19, 1981), the Thompsons reported Kersting
deductions of $72,840.
1981
The Thompsons late filed their 1981 tax return on July 19,
1982, reporting Kersting deductions of $80,782 as investment
interest expense.
The Kerstiñg deductions claimed on that return
were the principal factor in reducing the Thompsons' adjusted
gross income of $113,711 to taxable income of $18,685--a
reduction of $95,026.
The Thompsons also reported $8,000 of home
mortgage interest expense that was probably attributable to the
Bauspar program, in which the Thompsons began participating in
April 1981.
3.
Years Following Those Before the Court
1982
The Thompsons filed their 1982 tax return on May 6,
1983.¹°
On that return, the Thompsons reported Kersting (and probably
Bauspar) deductions sufficient to reduce their adjusted gross
income of $99,364 to taxable income of $4,336--a reduction of
¹°By October 1982, Mr. Thompson had retired as a pilot with
Continental Airlines.
- 18 $95,028.
Neither petitioners nor respondent have been able to
locate a copy of the Thompsons' 1982 tax return.
The 3-year
period of limitations under section 6501 expired with no action
by respondent concerning the Thompsons' 1982 tax return.
1983
The IRS received the Thompsons' 1983 income tax return on
July 2, 1984.
The Thompsons reported no tax liability on that
return; they also reported Kersting interest expense deductions
of $67,620 as well as Bauspar deductions.
1984
Respondent received the Thompsons'
April 1985.
1984 income tax return in
On that return, the Thompsons claimed Kersting
interest expense deductions from two Kersting programs:
"Mahaio"
(Mahalo), in the amount of $4,320, and Federated Finance, in the
amount of.$3,420.
The mortgage interest deduction included in
the return also included interest paid pursuant to the Bauspar
program.
be owing.
The Thompsons paid $2,269 as tax shown on the return to
.
1985
On their 1985 income tax return, the Thompsons reported
itemized deductions of $37,932 and reported adjusted gross income
of $22,507, resulting in zero taxable income.
Although the
Thompsons did not claim any Kersting deductions on the return,
- 19 they overstated their mortgage interest expense as a result of
their participation in the Bauspar program.
B.
Examination of the Thompsons'
1978-1981 Returns
The Thompsons experienced audit problems with their 1978 tax
return that were due, in part, to their failure to attach to the
return a Form W-2, Wage and Tax Statement, showing the amount of
income tax that Continental Airlines had withheld from Mr.
Thompson's wages.
In .early to mid-1986, the Thompsons' personal
counsel, Samuel.M. Huestis (Huestis), negotiated a settlement of
their income tax liability for 1978.
The record does not
disclose the terms of that settlement.
On May 5,
1983, the Los Angeles District Director issued a
statutory notice sof deficiency with respect to the Thompsons'
1979 taxable year, disallowing Kersting deductions of $39,477 and
determining a deficiency in tax of $18,161.
The notice of
deficiency also determined a negligence addition of $908 under
section 6653(a).
On July 11,
1983, the Thompsons filed a pro se
petition in this Court seeking a redetermination of the
deficiency and addition.
On. June 13,
1984, the Honolulu District Director issued a
statutory notice of deficiency with respect to -the Thompsons'
1980 taxable year, disallowing Kersting deductions of $72,840 and
determining a deficiency in tax of $24,838.
On September 4,
- 20 1984, the Thompsons filed a pro se petition in this Court seeking
a redetermination of the asserted deficiency.
On March 1, 1985, Kersting sent a letter to Kersting program
participants stating that he had retained attorney Brian Seery
(Seery) to represent them in the Tax Court 'at no charge to
individual petitioners.
The letter requested that each Kersting
program participant provide written authorization for Seery's
representation."
Seery's compensation for legal services
rendered to Kersting program participants was always paid by one
of Kersting's alter ego corporations.
On March 20,
1985, Seery
entered appearances for the Thompsons in their Tax Court cases
for their 1979 and 1980 taxable years.
He also entered his
appearance for hundreds of other taxpayers.
On May 31,
1985, the Los Angeles District Director issued a
statutory notice of deficiency with respect to the Thompsons'
1981 taxable year, disallowing.claimed Kersting deductions of
$80,782 and determining a deficiency in tax of $36,294.52.
The
notice of deficiency also determined negligence additions against
the Thompsons under section 6653(a)(1) and (2), a late filing
addition under section 6651(a)(1), and increased interest under
section 6621(c).
Respondent did not disallow the $8,000 claimed
"In a letter to program participants dated Aug. 11, 1986,
Kersting recommended that program participants not attempt to
resolve their cases on their own and instead rely on counsel he
had hired.
- 21 as home mortgage interest that was probably attributable to the
Bauspar program.
On August 13, 1985, the Thompsons filed a pro
042se
petition in this Court seeking a redetermination of the
asserted deficiency, additions, and increased interest for
1981.¹²
The Thompsons thus had three of their taxable years before
the Court in three docketed cases.
Respondent's determinations
of the Thompsons' Federal income tax deficiencies and additions
for their taxable years 1979-1981 were as follows:
Year
Deficiency
Additions to tax
.
Sec.
Sec.
6653(a)
6653(a) (1)
Sec.
6651(a)
1979
$18,161
---
$908
---
1980
24,838
---
---
---
1981
36,295
$4,934
---
$1,958
79,294
4,934
908
1,958
Total
·
Sec.
6653(a)(2)
---
--50% of the
interest due
on the
deficiency
---
Respondent also determined that the Thompsons were liable- for
increased interest for 1981 pursuant to section 6621(c).
On November 21,
1985, the Chief Judge of this Court assigned
all the Kersting project cases to Judge William A. Goffe
Goffe)
for trial or other disposition.
(Judge
Subsequent Kersting
project cases were automatically assigned to Judge Goffe.
¹²The Thompsons apparently filed their petition for their
1981 taxable year pro se, even after Seery had entered his
appearance in the earlier cases.
.
- 22 III. The Test Case Litigation and the Thompson Settlements
A.
Selection of the Test Cases
McWade and Seery planned to use the test case procedure to
dispose aof the cases of the Kersting program petitioners who
wished to contest the deficiencies determined against them by
respondent.
Most of these petitioners entered into stipulations
of settlement for tax shelter adjustments, also called "piggyback
agreements".
Respondent and petitioners who entered into
piggyback agreements thereby agreed to be bound by the results in
the selected.test cases.
On June 10,
1986, McWade and Seery
provided the names of the test case petitioners they had selected
to Judge Goffe.
Seery and McWade had agreed to the selection of test cases
in 14 dockets of seven married couples who had filed joint
returns and one individual who had not filed jointly.
Among the
couples selected to be test case petitioners were the Thómpsons,
John R. and E. Maria Cravens (the Cravenses), and Richard and
Fiorella Hbngsermeier (the Hongsermeiers).
Seery particularly sought to include the Cravenses as test
case petitioners because they treated their payments to Kersting
as basis reductions that resulted in capital gain upon the
termination of their interests in the programs.
The Cravenses
- 23 later decided to proceed without counsel and to settle their
cases."
Seery also selected the Hongsermeiers as test dase
petitioners because he mistakenly believed that they had used
their own funds, rather than "nontaxable distributions" from
Kersting corporations, to repay loans to other Kersting
corporations.
The Hongsermeiers' 1978-1980 taxable years were
before the Court; respondent had failed to audit their 1981 and
1982 taxable years.
There is no clear indication whether it was Seery or McWade
who originally proposed the participation of the Thompsons.
noted, the Thompsons'
Court.
B.
As
1979-1981 taxable years were before the
Respondent had failed to audit their 1982 taxable year.
Deterioration of the Thompson-Kersting
Relationship
Around the time Seery and McWade selected the test cases,
the relationship between the Thompsons and Kersting deteriorated.
Earlier in 1986, the Thompsons' personal counsel, Huestis, had
asked Kersting for an accounting of the Thompsons' participation
in the Kersting programs.
Huestis's request led to a dispute
between the Thompsons and Kersting.
On June 23, 1986, the
Thompsons retained John Chanin, a Honolulu attorney,. to help them
in their dispute with Kersting.
"See infra note 23.
In a letter dated August 23,
.
- 24 1986, Kersting informed the Thompsons he had.turned their file
over to his own attorney for collection and further stated:
The day after you have allowed your attorneys to file
suit I will declare all notes which you have executed
to our companies in default and begin collection
proceedings.
* * * The aggregate sum is well in
excess of $250,000.00,. as you know.
*
*
*
*
*
*
*
We will NOT provide legal assistance free of cost to
you any longer in US Tax Court proceedings. You will
have to retain your own attorney to make an appearance
for you on February 9/1987 in US Tax Court.
By letter dated August 24, 1986, Kersting notified Seery
that he expected to be in litigation with the Thompsons and
directed Seery not to "render any services, at our expense" to
the Thompsons.
On September 10,
1986, Huestis wrote to Seery,
notifying him that the Thompsons were seeking substitute counsel
and requesting their files.
On September 15, 1986, Seery sent
the Thompson files to Huestis and informed him that the Thompsons
were test case petitioners.
Seery indicated that he was
withdrawing as the Thompsons' counsel.
On October 28,
1986, Huestis again wrote to Seery to express
dissatisfaction with the sufficiency of the Thompsons' files and
to warn Seery that his earlier representation of the Thompsons,
while he was also apparently representing Kersting, could be
viewed as a conflict of interest and lead to an action for
"professional negligence".
On October 31, 1986, Seery filed
- 25 motions to withdraw as counsel in the Thompsons' cases, which the
Court granted.
In ruling on, a subsequent motion, Judge Góffe observed that
there could be a conflict of interest if Seery represented both
petitioners and Kersting.
Seery subsequently filed motions to
withdraw as counsel in the Kersting project cases
(both test
cases and nontest cases), citing concerns about a possible
conflict of interest.
The Court granted Seery's motions in
November 1986.
C.
The Thompsons Engage DeCastro, Who Settles
Their Cases
On or about November 15,
1986, the Thompsons retained
attorney Luis DeCastro (DeCastro), who was also a certified
public accountant, to settle their Kersting tax issues.
Mr.
Thompson retained DeCastro to resolve all the Thompsons' Kersting
.
tax years, not only the 1979-1981 years docketed in the Tax
042
Court.
The Thompsons provided DeCastro with tax records for all
those years.
The retainer agreement between the Thompsons and
DeCastro provided for a $5,000 fee, which covered only efforts to
negotiate a settlement; it did not cover preparation for and
conduct of a trial.
None of the other petitioners in the
Kersting project, whether test case petitioners or piggybackers,
incurred any attorney's fees in connection with the preparation
and trial of the test cases.
Kersting paid all such fees.
- 26 Meanwhile, in the wake of Seery's withdrawal, Kersting
engaged attorneys Robert J. Chicoine (Chicoine) and Darrell D.
Hallett (Hallett) to represent the test case petitioners
(other
than the Thompsons and the Cravenses) at the Tax Court's trial
session in Maui, Hawaii, which had been scheduled to commence
February .9,
1987.
Chicoine and Hallett agreed to do so with the
understanding that they would not represent Kersting.
In late
1986, Chicoine and Hallett apparently indicated to McWade and
Sims that they intended to challenge the admissibility of
evidence that had been seized in the January 1981 search of
Kersting's office that became the subject of this Court's opinion
in Dixon v. Commissioner, 90 T.C. 237 (1988)
supra note 2.
(Dixon I).
See
About the same time, McWade and Sims began to
offer 20-percent reduction settlements that were based on the
same general approach as their modified 7-percent reduction
settlement offer that included the burnout feature.
In December 1986, DeCastro traveled to Hawaii on behalf of
the Thompsons and a number of other clients who had participated
in the Kersting shelters. . There DeCastro, accompanied by Gary
Poltash (Poltash), the Thompsons' new accountant, who was not
associated with Kersting, began settlement discussions with
McWade.
Their initial agreement called for a reduction in the
Thompsons'
1979-1981 deficiencies of approximately 18.8 percent.
The settlement also provided for the elimination of all additions
- 27 to tax and for the elimination of the increased interest rate
under section 6621(c) for 1981.
The burnout would also apply so
as to combine the agreed deficiencies for the years 1979 and 1980
in the year 1980.
During this trip, DeCastro and McWade also
discussed the Bauspar program in which the Thompsons were
involved.
On December 23, 1986, McWade signed and sent DeCastro
stipulated decision documents in the Thompsons' cases.
The
transmittal letter stated that:
As previously indicatéd, the Decision documents
in John R. and Maydee Thompson will not be filed with
the Court until the Decision becomes final in the test
cases.
In the interim, the Thompsons can make an
advance payment, as discussed at our conference, and
stop the accrual of any additional liability for
interest.
On December 30,
1986, DeCastro signed and returned to McWade the
executed decision documents agreeing to the reduced deficiencies.
Neither McWade nor Sims communicated the terms or existence of
the Thompsons' settlement to their superiors.
The result of the pending settlement upon the Thompsons' tax
liabilities would have been as follows:
Determined
Deficiency
Proposed
Settlement
Percentage
Reduction
1979
$39,477
1980
72,840
Total
$18,161
24,838
42,999
--$34,425
34,425
20
1981
80,782
All years total
36,295
79,294
30,000
64,425
Year
Income
Adiustment
.
17
18.8
- 28 -
DeCastro, Poltash, and McWade had also agreed that the
Thompsons would be able to deduct the interest payable on the
deficiencies agreed to under the settlement by prepaying such
interest by December 31, 1986."
As of December 31, 1986, the
accrued interest on the Thompsons' newly settled deficiencies was
$35,275.81 for 1980, and $24,270.62 for 1981--a total of
$59,546.43, which the parties rounded to $59,545.
Accordingly,
the decision documents returned to McWade by DeCastro stated:
"By separate cover you will also be receiving a check in the
amount of $59,545 representing interest on the tax deficiencies
reflected in the decision documents."
December 30,
With a letter dated
1986, Mr. Thompson sent McWade two checks:
check
No..54 for $34,000, and check No. 242 for $25,545, for a total of
$59,545.
Mr. Thompson's letter stated:
"I am at the present
time doing the necessary procedures to take care of the balance."
At McWade's direction,
payment posting vouchers
IRS personnel in Honolulu prepared
(Form 3244) allocating the Thompsons'
prepayment of $59,545 between the 2 years before the Court,
"The Internal Revenue Code was amended in 1986 to add a new
sec. 163(h) that repealed the deduction for "personal interest".
See TRA sec. 511(b), 100 Stat. 2246.
Under the new sec. 163(h),
1986 was,the last taxable year in which taxpayers could deduct
100 percent of such personal interest.
TRA sec. 511(e), 100
Stat. 2249.
For 1987, only 65 percent of personal interest was
deductible, and the deduction for personal interest was phased
out entirely by the end of 1989.
Sec. 163(h)(6).
- 29 indicating designated interest for 1980 in the amount of
$35,275.78 and designated interest in the amount of $24,269.22
for 1981.
The entire amount of check No. 242 ($25,545) and
$9,730.78 from check No. 54 was applied to 1980; the remainder of
check No. 54
($24,269.22) was applied to 1981.
The Thompsons'
$34,000 check (check No. 54) was subsequently dishonored.
This
was reflected as a debit for the Thompsons' accounts for 1980 and
1981.
In February 1987, the Thompsons made a replacement payment
of $34,340, representing the amount of the dishonored check plus
a 1-percent bad check penalty.
The replacement payment was
restored as a credit as of December 31,
1986.
The Thompsons were the only test case petitioners for whom
the IRS processed a prepayment of interest without receiving a
concurrent "advance payment on deficiency" to which the interest
was attributable.
In January 1987, Chicoine and Hallett filed motions in this
Court seeking to suppress the evidence that.had been seized in
the raids on Kersting's office and to shift to respondent the
burden of proof and burden of going forward with evidence.
The
Chicoine and Hallett motions in effect turned the February 1987
Maui trial session into a hearing on the motions.and resulted in
a cóntinuation of the trial of the test cases.
On March 13, 1987, McWade sent DeCastro a revised decision
document for the Thompsons'
1980 taxable year, making a.minor
- 30 change that reduced the deficiency for that year from $34,425 to
$33,000.
McWade later explained:
miscomputed something."
"It must have been I
With this modification of the
settlement, the Thompsons' aggregate deficiencies for 1979-1981
were reduced by 20...55 percent of the deficiencies originally
determined by respondent (i.e., from $79,294 to $63,000).
On June 15, 1987, DeCastro sent a $63,000 cashier's check
"in partial payment of the total amount due" to the Internal
Revenue Service Center in Fresno on behalf of the Thompsons.
Respondent received the payment of $63,000 on June 17, 1987, and
credited it to the Thompsons'
1979 account as an advance payment,
less offset of a credit of $775 that was applied to their 1988
tax year.
Accordingly, by June 1987, the Thompsons' payments to
the IRS with respect to the taxable years 1979-1981 totaled
$121,770 ($62,225 as an advance payment of tax, and $59,545 as
interest) .
D.
IRS Activity Regarding the Thompsons'
1983-85 Returns
In the meantime, an employee of respondent at the Fresno
Service Center in California (with initials A.A.K.) prepared a
statutory notice of deficiency (subsequently dated March 17,
1987) disallowing $67,620 of Kersting'deductions claimed on the
Thompsons'
1983 income tax return.
Because the Thompsons had
little taxable income that year, the first whole year of Mr.
- 31 Thompson's retirement, the deficiency resulting from this
disallowance was only $980.
There is some indication that the
notice of deficiency was mailed and that it caused an inquiry.
An internal document of the IRS (Form 4700) reflects a
handwritten entry dated May 8,
determination - refiling case."
1987:
"No reason to change
Nevertheless, no petition for
the Thompsons' 1.983 taxable year was filed in this Court, and the
deficiency was never assessed or collected.
On October 6, 1987, Revenue Agent Carolyn Speers
based in San Jose, California, audited the Thompsons'
(Speers),
1984 income
tax return and noted $7,740 of Kersting deductions claimed on the
return.
On that date, she wrote the Thompsons a letter proposing
to dispose of the Kersting issue identified on the return
consistent with respondent's general 7-percent reduction
settlement proposal.
In her letter, Speers also requested
additional information regarding the Thompsons' participation in
the Kersting tax shelter programs, including a request for a copy
.of the Thompsons'
1985 income tax return.
Speers did not receive a response from the Thompsons to her
October 6,
1987 letter nor to a followup letter dated November
17,
On November 27, 1987, Mr. Thompson called Speers to
1987.
report that he had forwarded her request to DeCastro.
On December 23,
1987, DeCastro sent Speers an executed copy
of the 7-percent reduction settlement agreement for 1984, along
- 32 with a power of attorney executed by the Thompsons for the
taxable years 1984 and 1985, and a Form 872-A, Special Consent to
Extend the Time to.Assess Tax.
Because DeCastro did not include
the requested additional information or a copy of the Thompsons'
1985 return, Speers declined to proceed on the basis of the 7percent reduction settlement.
Instead, by letter to DeCastro
dated January 12, 1988, Speers proposed to dispose of the
Thompsons'
1984 year by disallowing the claimed Kersting interest
expense deductions in their entirety.
of the Thompsons'
She.again requested a copy
1985 return "to verify that interest from
Kersting was not deducted in this year."
Beginning October 6,
February 24,
1987, and continuing through
1988, Speers documented (in her case history
worksheet) telephone or written contact in the course of her
examination of the Thompsons'
1984 income tax return with the
Thompsons, DeCastro, Philip Hoskins (of DeCastro's firm), and an
accountant named "Rick."
Speers's case history worksheet
reflects no contacts with McWade, Sims, or any other of
respondent's counsel.
By letter dated February 22, 1988, DeCastro agreed to a
complete disallowance of the $7,740 of Kersting deductions
claimed by the Thompsons for 1984 and the resulting deficiency of
$1,863.
The Thompsons paid the deficiency and interest; by
-
33
-
.
.
virtue of this disposition of the matter, respondent issued no
notice of deficiency to the Thompsons for 1984.
On March 4, 1988, DeCastro sent Speers a copy of the
Thompsons' 1985 income tax return.
As noted above, the
Thompsons' 1985 income tax return did not reflect any Kersting
deductions (although it did include Bauspar deductions).
letter dated March 25,
In a
1988, Speers notified.the Thompsons that
she "was able to verify that interest from the Kersting project
was not deducted" on that return.
Respondent issued no notice of
deficiency to the Thompsons for 1985.
E.
The Reporting and Resolution of the Thompsons'
Deficiency Interest Payments for 1986 and 1987
The Thompsons claimed their $59,545 interest payments to the
·IRS as an itemized interest deduction on Schedule A - Itemized
Deductions of their 1986 income tax return.
However, because
their adjusted gross income for that year was relatively low, the
Thompsons were able to use only $16,251 of the $59,545 deduction.
The Thompsons did not claim any Kersting or Bauspar deductions on
their.1986 return.
Poltash prepared the Thompsons'
1987 income tax return.
On
that return, the Thompsons deducted $27,914 as interest paid to
the IRS.
That figure represents 65 percent of $42,945.
supra note 14.
See
Apparently, the Thompsons were attempting to
carry over the unused portion of the interest deduction of
- 34 $59,545 from their 1986 taxable year.¹³
The Thompsons did not
claim any Kersting or Bauspar deductions on their 1987 return.
Poltash did not discuss the preparation of the Thompsons' 1986 or
1987 returns with McWade or Sims.
Revenue Agent Speers examined the Thompsons'
return.
1986 income tax
She asked about the $59,545 interest deduction in
letters to the Thompsons dated February 26 and March 25,
In a telephone conversation with Speers on May 23,
1988.
1988, Mr.
Thompson explained the $59,545 interest expense deduction to her
satisfaction.
Speers closed the examination of the Thompsons'
1986 return without making any adjustments to the return.
Her
examination workpapers reflect her notation that "TP paid large
interest to IRS on Schedule A--verified per transcripts."
In June 1989 a revenue agent¹6 screened the Thompsons'
income tax return for Kersting deductions.
1987
The return bears a
stamp stating "Income Tax Survey After Assignment", meaning that
the agent saw nothing obvious for examination and returned the
15Although Poltash claimed to lack any recollection of his
attempt to claim the interest deduction, he conceded the $42,945
amount might have represented an attempt to claim for 1987 the
portion. of the $59,545 claimed on the 1986 return that produced
no tax benefit to the Thompsons. We note a slight discrepancy
between the amount of the deduction actually used on the
Thompsons' 1986 return ($16,251) and the figure underlying the
$42,945 "carryover" for 1987 ($59,545 - $42,945 = $16,600).
¹6The signature of the examining agent is difficult to
decipher; it appears to be "Art (or Pat) Taylor."
- 35 1987 return to files without examining it or transmitting it for
examination.
F.
The Thompson Settlement Revised as Trial Approaches
Although Chicoine and Hallett ultimately recommended that
their test case clients accept respondent's 20-percent settlement
offer, Kersting disagreed and replaced Chicoine and Hallett with
attorney Joe Alfred Izen, Jr.
042
(Izen)
in April 1988.
Counsel on
both sides began to prepare for trial, which was scheduled for
January 1989 in Honolulu, Hawaii.
In an order dated August 30,
1988, the Court granted
McWade's motion to depose Kersting.
In October 1988, while in
Honolulu for the Kersting deposition, DeCastro met McWade to
discuss the Thompson cases.
DeCastro told McWade he wanted to
withdraw the Thompsons from the test case trial.
DeCastro's
reason for withdrawing the Thompsons was to avoid their having to
pay the fees and expensés of the trial and to enable them to take
the settlement they had already agreed to.
McWade wanted to keep
Mr. Thompson as a party to the trial because he was a test case
petitioner who was represented by an attorney, DeCastro, who had
not been hired.and paid by Kersting.
From respondent's
standpoint, there was also a benefit to having, as a party
witness, a participant in the Kersting program who was feuding
with Kersting and could be expected to testify against him.
- 36 Recalling the. withdrawal of Seery, Sims was concerned by the
potential conflict of interest from Kersting's paying the fees of
the attorney representing the test case petitioners.
.
Accordingly, he wanted to keep DeCastro in the trial of the test
cases as an independent attorney, paid by the taxpayer, to
provide an apparent safeguard against the trial appearing to be
slanted toward protecting the promoter's
petitioners') interest.
(as opposed to
.
McWade and DeCastro also apparently discussed the statús of
an outstanding Federal tax lien on the Thompsons' house
.(unrelated to their participation in Kersting shelters), which
the IRS had yet to remove more than a year after the Thompsons
had satisfied the underlying liability."
On November 22,
1988,
respondent issued a certificate of release with respect to the
Federal tax lien on the Thompsons' house.
Shortly before trial of the test cases in this Court in
January 1989, McWade and DeCastro reached an oral agreement (the
new agreement) calling for reduced amounts of agreed deficiencies
for 1979-1981 of zero, $15,000, and $15,000, respectively.
The
purpose of the reductions was to compensate the Thompsons for the
cost of having an attorney represent them at the trial of the
"Under sec. 6325(a)(1-), the IRS was required to release the
lien not later than Oct. 7, 1987, 30 days after the liability had
been satisfied.
- 37 test cases.
DeCastro estimated that his legal fees for
representing the Thompsons at the trial of the test cases would
be approximately $60,000.¹ª
It was estimated that the newly
agreed reductions would generate approximately $60,000 of refunds
to the Thompsons from the $121,770 they had paid earlier toward
satisfaction of the deficiencies and interest under the earlier
settlement.
The new agreement also preserved the Thompsons'
chances to prevail on the merits of the litigation.
McWade and
DeCastro agreed that if the results of the trial were more
favorable to the Thompsons than the new agreement, the Thompsons
would be entitled to the results of the trial.
·
When the new agreement was reached, respondent's official
settlement policy still provided for a 7-percent reduction in
determined deficiencies, elimination of the negligence penalty,
and other minor concessions, although, as the time for trial
approached, some nontest case petitioners' attorneys continued to
negotiate 20-percent reduction settlements.
The new agreement,
¹ªAs petitioners point out, DeCastro was somewhat
inconsistent in his recollection of his proposed billing. On
June 2, 1992, he initially denied that the new agreement was
designed as a mechanism for respondent to pay his fees, but he
admitted to the contrary 8 days later. On Aug. 11, 1992,
DeCastro recalled estimating that it would cost a minimum of
$30,0.00 to try the Thompsons' case. After being shown documents
indicating he had billed the Thompsons for more than $30,000,
DeCastro said he had told McWade that his fees would be roughly
$65,000. As respondent points out, DeCastro's bills to.the
Thompsons, as of Nov. 29, 1989,. totaled $58,738.20.
- 38 however, reduced the Thompsons' deficiencies for the years at
issue from the originally determined $79,294 to $30,000--a
reduction of 62.17 percent.
The new agreement substantially
deviated from respondent's official settlement policy and from
the 20-percent reduction settlements obtained by DeCastro and
Chicoine and Hallett and other attorneys on behalf of other
clients.
None of Sims's or McWade's superiors approved the new
agreement.
To the contrary, Sims's and McWade's superiors did
not discover the new agreement until after this Court had tried
the test cases, issued its opinion, and entered its initial
decisions therein.
G.
Trial and Entry of Decisions
The trial of the test cases was conducted before Judge Goffe
from January 9 through January 27,
1989, at Honolulu, Hawaii.
Neither Sims, McWade, nor DeCastro informed Judge Goffe, the
National Office, the Regional Office, or Izen of the Thompson
settlement c»: the Cravens settlement before or during the January
1989 trial of the test cases, or thereafter.
The Government paid the travel, food, and lodging expenses
of Mr. Cravens and Mr. Thompson while they were in Hawaii.
Thompson's reimbursed expenses amounted to $1,105.13.
in Dixon III, n.53:
Mr.
We stated
"Inasmuch as respondent subpoenaed all the
test case petitioners, it is assumed they were all reimbursed for
their expenses."
Although there is no evidence in the record
I
- 39 that any other test case petitioner, other than Mr. Cravens and
Mr. Thompson, was reimbursed by the Government for the expenses
of attending the test case trial, neither is there any record
evidence that any or all of the other test case petitioners who
requested reimbursement of their trial attendance expenses had
their requests denied, or indeed that requests for reimbursement
were made by any such petitioners.
Around the time of the 1989 trial, DeCastro asked McWade to
arrange for the Thompsons to receive a refund of $30,000 of their
advance payments.
In.a memórandum dated April 10, 1989, McWade
requested respondent's administrative officials to process a
$30,000 refund to the Thompsons.
On July ll, 1989, the
Government issued a refund check of $30,000 to the Thompsons.
The Thompsons endorsed the check to DeCastro Law Corp. without
depositing it in their own checking account.
The Thompsons did
not claim a deduction on their 1989 return for the $30,000 they
paid DeCastro.
On August 3,
1989, DeCastro wrote a letter to McWade
confirming the revision of the Thompson settlement that had been
agreed to before the trial of the test cases.
states in pertinent part as follows:
DeCastro's letter
- 40 Re: Jack and Maydee Thompson
Dear Ken:
Please confirm following is our agreement with
respect to settlement of above.taxpayer's cases. for
open years:
We have agreed that the total taxes due for all
the open years are $15,000 for 1980 and $15,000 for
1981.
Further, in the event a final decision in this
case is more favorable they are to receive the benefit
of such decision.
Please sign below so I can have for my files.
McWade signed the letter and returned it to DeCastro.
On August 24, 1989, DeCastro wrote McWade requesting him to
arrange for the Thompsons to receive the balance of their refund.
McWade replied that the balance would not be released until the
Tax Court had issued its opinion, and DeGastro so informed.the
Thompsons.
DeCastro told the Thompsons that, because the ·IRS
would be paying interest, he -believed it was fair to add interest
to the Thompsons' bill.
On or about November 6, 1989, McWade received an undated
letter from Mr. Thompson, which stated in pertinent part as
follows:
Dear McWade:
There are some questions in mind that I feel you can
help me answer.
_ 41 _
I received a check from IRS in the amount of thirty
thousand dollars--($30,000). I endorsed this over to
DeCastro Law Corp; this did not retire the billed
amount.
I am completely amazed at the billings we are
receiving.
I am now in receipt of additional billings
that exceed realistic amounts.
In fact the total comes
to sixty six thousand two hundred forty three and
66/100 dollars ($66,243.66). At some point I know a
reconciliation will come.
Luis [DeCastro) says don't
be concerned.
I am very concerned, I am the one being
billed.
.
Most emphatically I did not expect to be a channel
through which IRS funneled funds to any law firm.
Certainly not in this magnitude.
I have the feeling at
this point that I am correct in this--the bill is to
[sic] much.
I want to know the exact legal position I
occupy. We have been frustrated long enough.
We wish
to close this chapter.
DeCastro wrote to Huestis on November 17, 1989, stating, in
pertinent part:
Thank you for your letter regarding the matter of
the Thompsons' fees. As I have told Jack, we are
looking for payment of his fees to the IRS, not him.
I
am enclosing a copy of my letter to him in this regard
for your information.
DeCastro sent a similar letter to the Thompsons on the same
date.
On December 11, 1991, the Court issued its opinion in Dixon
v. Commissioner, T.C. Memo. 1991-614
(Dixon II),
sustaining .
almost all of respondent's determinations .that the Kersting
programs at issue lacked merit for tax purposes.
- 42 On March 13,
1992, the.Court entered decisions against
petitioners in the test cases in accordance with its opinion.
On May 14, 1992, the test case petitioners--other. than test case
petitioner Ralph J. Rina (Rina) and the Thompsons and the
Cravenses--appealed the decisions in their cases to the Court of
Appeals for the Ninth Circuit.
H.
Discovery and Disclosure of the Thompson
Settlements
On May 8, 1992, Sims and McWade, 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 Sims's and McWade's request to process the Thompson
settlement.
Bakutes informed Benjamin Sanchez (Sanchez), the
Western Regional Counsel in San Francisco, who informed officials
in the National Office of the Office of Chief Counsel in
Washington, D.C.
.The ci-rcumstances surrounding the Thompson
settlement became a matter of 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
- 43 the decisions entered on March 13, 1993, 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
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 was prepared
to appeal any decision to the contrary.
Bakutes prepared a motion that was filed in this Court on
June 9,
1992, seeking leave to vacate the decisions entered in
the Thompson cases, as well as the Cravens and the Rina cases.
Respondent requested the Court to conduct an 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 June 10, 1992, Judge Goffe granted respondent's motions
to vacate filed in the Thompson and the Cravens cases.
That same
day, Bakutes called DeCastro to tell him that the decisions in
the Thompson cases had been vacated.
During this call, DeCastro
told Bakutes that in 1988 McWade had reduced the Thompsons'
deficiencies to keep the Thompsons in the case.
Although he had
- 44 earlier told Bakutes that attorney's fees were not awarded in.the
settlement, DeCastro admitted in this conversation that the
deficiencies were reduced to pay the Thompsons' legal fees for
his representation of them in the test case trial.
On or about June 11, 1992, Sanchez decided that Sims and
McWade should no longer have any authority over the Kersting
cases and that.the cases should be assigned to other attorneys
who had been involved in the Kersting Sroject.
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, Judge Goffe denied respondent's request for
an evidentiary hearing and ordered the parties to file agreed
decisions with the Court, "or otherwise move within 30 days of
the date hereof."
In a separate order filed on the same date, the Court denied
respondent's motion to vacate the decision filed in Rina's 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
-.45 Relating specifically and expressly to the Cravenses or
the Thompsons), and the Court's findings, analyses, and
donclusions re.lating to petitioner Rina would remain
the same. * * *["]
.
During the.summer of 1992, respondent's Acting Chief Counsel
David Jordan (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
9
settlement on behalf of the National Office.
Kane and Miller
conducted in-house depositions and 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 the parties file
agreed decisions with the Court or otherwise move within 30 days.
Dombrowski learned that McWade and Sims had denied that the
042
purpose of the new agr.eement to reduce the Thompsons'
deficiencies was to pay DeCastro's fees; instead, they claimed,
the lowered deficiéncies had something to do with the Thompsons'
2.?Rina. appealed from this denial. Unlike the Thompsons,
Rina had~ no settlement agreement with Sims and McWade. On June
13,.199$-, Rina agreed to the entry of a stipulated.decision in
the amounts origi-nally.determined in his statutory notice4 of
deficiency.
reduced to $62,225 ånd then $32,225) '.
Dombrowski requestéd
"audit "assistance", which he 'feceivéd fro'm George Guzzardo
(Guzzardo)", an appèals äudiEdr in respondent's San(Diego office,
in 'determining .whether the Thomp'so s were ehtitled tó the
requested'-ihterést'.
.,
Guzzafdo detërmined that thé Thompsons'
..
$63, 000 r'e°rnitt nce on June 17, 1987p w'á 541
an édvance paynient
.rather than a 'ca h bond.
The distinction is ·importànt i
An .
advance payment resulting in an overpayment entitles the taxpaper
to inte est"on the overpayment; 'conversely, a cash bond does not
earn it teres .
Haviñcj' co cldded 'Éhat the preifiously refunded .
$62,225 'wad-añ àdéa'ncé j5ayment, Guzzardo determined th'àt the
Thóróp's'ons werfen'titledW6 additional iñterest'of $31, 511.17 as
of July 31, 199 540 Dombróias'ki did his owh computations). arid then
ask 540a
Jeañ da Üls (Sam'uéls)3 an experiénced #ppeals1auditor, to·
check his and Guz ar'clo's figúres.
main
le
Saittuels adirised that·in the
g e d wiDh'both GtYzzafdo's'a'nd Dômbrowski'~s -"- · ·
calculations.
5031ativély srnall di'fferpncés. in théir ^resu·lts were
attributable.
o theiË use of différênt dates' for the accrual- of
.interes.t'..2
On September 17, 1993, Dombrowski séñt ·Bákútes a memorandum
requestiñg 6p roval to rèfund thet 'interést on the Thomps.dús'
2ASamuels saw that he refund inclúded somedpréviously
deducted interest, thus producing tax benefit income, but stated
in hef m'ediérandudÕ to DodibroWskii,' "Most táxpaýeis would probably 2
either not know or not remember to include this [tax benefit
income) in income, since they won' t get a Form 1099 for it~."
- 55 overpayments, with a copy to the National Office. . Bakutes
approved the refund in an e-mail message to Dombrowski.
In
October 1993, respondent issued a refund check to the Thompsons
in the amount of $32,116.68.
Finally, in December 1993, respondent issued a refund check
of $4,107.93 to the Thompsons for 1980.
The check represented an
overpayment credit of $2,257.54 (the amount by which their
$59,545 interest payment exceeded their deficiencies and interest
for 1980 and 1981 after minor adjustments), plus accrued interest
of $1,850.39 on the overpayment credit.
The Thompsons deposited these last two refund checks in
their checking account.
The following table summarizes the payments by the Thompsons
to respondent as well as the subsequent payments, as refunds and
interest on refunds, by respondent to the Thompsons:
Paid by Thompsons:
.
$59,545
December 31, 1986 and February 17,
1987 payments of interest on
deficiencies under original settlement.
62,225
June 1987 advance payment of
deficiencies for 1979-1981 (net
of $775 credited to tax year 1988).
121,770
Total amount paid for years in issue.
- 56 Received by Thompsons:
$30,000.00
Refunded July 11, 1989, pursuant to
request of McWade,. endorsed to
DeCastro.
32,225.00
Refunded February 19, 1993,. pursuant
to request of DeCastro and endorsed
to DeCastro.
32,116.68
Third refuhd check, dated October 22,
1993, for $32,116.68, representing
interest on overpayment resulting from
advance payment of deficiencies.
4,107.93
Refund, with interest, of overpayment
resulting from application of $59,545
interest payment against 1980-81
deficiencies and interest.
98,449.61
Total amount refunded by IRS
for years in issue.
In sum, the Thompsons were refunded $98,449.61 of the
$121,770 they had paid in deficiencies and interest for 1979-
1981.
Of the $98,449.61 refunded, $81,225 was paid to DeCastro
as legal fees.
Of this amount, $62,225 was paid to DeCastro by
the Thompsons' endorsement to him of the first two refund checks
they received in 1989 and 1993.
The Thompsons apparently paid
DeCastro an additional $19,000 after receiving the third refund
check later in 1993.
On their 1993 tax return, the Thompsons reported both the
$32,116 interest income received from the IRS in October and the
smaller interest payment of $1,850 received in December.
Their
return did not reflect the tax benefit arising from the fact
that, while they deducted $44,165 of deficiency interest on their
- 57 1986 and 1987 returns ($16,251 for 1986 and $27,914 for 1987),
the interest on the reduced deficiencies that were ultimately
assessed in 1993 amounted to only $27,506 ($15,371.for 1980 and
$12,135 for 1981).
Pursuant to written advice from DeCastro, the
Thompsons deducted the fees paid to him in 1993 totaling $51,225
($32,225 + $19,000) in computing their taxable income.
The
description accompanying the deduction claim on the Thompsons'
1993 return was "LEGAL FEES FOR INCLUDABLE INC."25
J.
Respondent's Disciplinary Action
Against Sims and McWade
On July 29, 1993, Sanchez 'sent notices of proposed
disciplinary action to Sims and McWade.
that Sims and McWade had violated:
The notices asserted
(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 Cónduct 214.5
25The reference to "INCLUDABLE INC." has not been
satisfactorily explained, even by Poltash, whose office prepared
the, return.
Petitioners urge that the. reference is to "an entity
that never existed." The Court doubts the reference is to an
entity at all, but the Court's question to Poltash, whether the
reference was a shorthand reference to "includable income", as a
justification for deductibility.under sec. 212, met with a
protestation of ignorance.
- 58 (an employee will not intentionally make false or misleading
verbal or written statements in matters of official interest).
The notices proposed to suspend both Sims and McWade for 14
calendar days without pay.
McWade retired from the IRS effective October 2, 1993.
November 2,
On
1993, Acting Chief Counsel Jordan approved Sanchez's
proposed disciplinary action.
Sims was suspended from duty
without pay for 14 days 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.
IV.
Ninth Circuit Remand and Subsequent Proceedings
A.
Ninth Circuit Orders in the DuFresne Case
On June 14,
1994, the Court of Appeals for the Ninth Circuit
filed a per curiam opinion, vacating and remanding this Court's
decisions in the remaining test cases, on the ground that the
misconduct of Sims and McWade required further inquiry.
v. Commissioner, 26 F.3d at 107.
DuFresne
Citing Arizona v. Fulminante,
499 U.S. 279, 309 (1991), the Court of Appeals observed:
We cannot determine from this 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. * * *
Accordingly, the Court of Appeals remanded the remaining test
cases to this Court with directions "to conduct an evidentiary
- 59 hearing to determine t.he full extent of the admitted wrong done
by the government trial lawyers."
Id.
It further directed this
Court to "consider on the merits all motions of intervention
.
.
filed by parties affected by this case."
£d.
Finally, the Court
indicated that "All subsequent appeals will be scheduled before
this panel."
Id.
Notwithstanding its general endorsement of allowing parties
042
in related cases to intervene, the Court of Appeals for the Ninth
Circuit dismissed attorneys Izen's and Sticht's appeals from this
Court's denial of their motions to intervene in the Thompson and
Cravens cases.
In an unpublished opinion filed the same day as
the DuFresne opinion, the panel of the Court of Appeals.that had
decided DuFresne explained:
The Tax Court's August 25 and 26, 1992 decisions
entering settlement in the Cravens and Thompson cases,
respectively, are final. 26 U.S.C. § 7481(a)(1); Fed.
R. App. P. 13.
The Tax Court lacks jurisdiction to
vacate those decisions. Billingsley v. CIR, 868 F.2d
1081, 1084 (9th Cir. 1989). Because there is no case
remaining in which the taxpayers can intervene, this
appeal is moot.
[Adair v. Commissioner, 26 F.3d 129
(9th Cir. 1994).]
On September 29,
1994, the District Court for the District
of Hawaii entered an order in favor of the United States that
approved the assessment of penalties of $1,545,201 and $2,230,000
under sections 6700 and 6701 against Kersting for the promotion
of abusive tax shelters.
Kersting timely appealed.
- 60 In December 1994, the Tax Court received the mandate of the
Court of Appeals in DuFresne, and the test cases were assigned to
Judge Beghe for further proceedings under the mandate.
B.
Evidentiary Hearing and Opinions
After the Remand in DuFresne
In response to respondent's motion for the evidentiary
hearing required by the mandate, this Court,
following receipt of
the record from the Court of Appeals, set the test cases for a
pretrial hearing to be held July 17, 1995.
In furtherance of the
Court of Appeals' directive regarding intervention, the Court
ordered that notice of the hearing be served on all attorneys who
had entered appearances on behalf of nontest case petitioners in
the Kersting project.
Ultimately, the Court ordered that 10
cases of nontest case petitioners, each represented by either
Izen, Sticht, or attorney Robert Alan Jones (Jones), be
consolidated with the remaining test cases for purposes of the
evidentiary hearing.
As a result, three groups of petitioners
participated in all subsequent phases of the evidentiary hearing:
Test case. and nontest case petitioners represented by Izen;
nontest case petitioners represented by Sticht; and nontest case
petitioners represented by Jones.26
26The group of cases that were consolidated for purposes of
the evidentiary hearing initially included the case of William D.
and Karen S. Booth, docket No. 28950-88, in which Declan J.
O'Donnell (O'Donnell) had entered his appearance. However, at
the start of the evidentiary hearing, the Court granted
(continued...)
- 61 As directed by the Court of Appeals in DuFresne, Judge Beghe
conducted the evidentiary hearing at special trial sessions of
the Court in Los Angeles, California, from May 13-30 and
June 10-26, 1996, and August 18, 1997.
On March 30, 1999, on the
basis of the record developed at the evidentiary hearing, the
Court issued its supplemental opinion in Dixon v. Commissioner,
T.C. Memo. 1999-101 (Dixon III).
The Court held that the
misconduct of the Government attorneys in the trial of the test
cases did not, in the words of the Court of Appeals for the Ninth
Circuit in DuFresne, constitute a "structural defect" in the
trial, but rather resulted in "harmless error".
However, the
Court imposed sanctions against respondent, holding that Kersting
program participants who had not had final decisions entered in
their cases would be relieved of liability for (1) the interest
component of the addition to tax for negligence under section
6653(a)(1) (B) and (2), and (2) the .incremental interest
attributable to the increased rate prescribed in section 6621(c).
26(...continued)
O'Donnell's motion to sever the Booth case from the cases
consolidated for the evidentiary hearing. O'Donnell argued that,
in light of the theory underlying a motion for summary judgment
that he had filed on behalf of the Booths, they had no need to
participate in the evidentiary hearing.
In Gridley v.
Commissioner, T.C. Memo. 1997-210, the Court denied O'Donnell's
motions for entry of decision consistent with the final Thompson
settlement.
- 62 On March 13, 2000, the Court of Appeals for the Ninth
Circuit affirmed the order of the Hawaii District Court that had
imposed almost $3 million in penalties against Kersting for the
promotion of abusive tax shelters.
The opinion of the Court of
Appeals states:
The district court did not err in finding that
Kersting knew or had reason to know that his statements
concerning the allowability of interest were false or
fraudulent. See 26 U.S.C. § 6700(a)(2); * * *. The
record indicates that Kersting knew that his tax
shelters were sham transactions in which participants
could write off approximately twelve dollars for every
dollar of actual out-of pocket expenses. Kersting
himself indicated in a 1977 "comfort letter" to one of
the "nervous nellies" investing in his scheme that
these deductions were not legitimate - Kersting warned
the individual to "be sure this letter does not get
into the wrong hands.
If IRS would become aware of the
offsetting character of your note you would likely lose
your interest deduction".
Kersting also knew that these fraudulent interest
deductions originating in a prior version of his tax
shelter had been previously disallowed by this Court.
See Pike v. Commissioner, 78 T.C. 822 (1982) (denying
interest deductions to taxpayers participating in
Kersting's tax shelters because the transactions
conducted by Kersting's corporations were shams lacking
economic substance), affd., 732 F.2d 164 (9th Cir.
1984). .After Pike, Kersting made merely cosmetic
changes to his tax shelter scheme. * * *
Kersting v. United States, 206 F.3d 817, 819 (9th Cir. 2000).
On March 31, 2000, this Court issued a supplemental opinion,
Dixon v. Commissioner, T.C. Memo. 2000-116 (Dixon IV), awarding
petitioners some of the attorney's fees they sought for services
performed in the evidentiary hearing mandated by the Court of
Appeals in DuFresne and denying their motions for additional
- 63 sanctions.
In so doing, the Court denied petitioners' requests
for the award of attorney's fees under section 7430, on the
ground that Dixon III had held that none of them was a
"prevailing party" as defined in section 7430(c)(4).
Instead,
the Court awarded fees under section 6673(a)(2), which authorizes
the Tax Court to require the United States to pay excess costs,
expenses, and attorney's fees whenever the Commissioner's
attorneys have "multiplied the proceedings in any case
unreasonably and vexatiously".
On the same date, the Court entered decisions in the test
cases, and the test case petitioners appealed.
The Court also
certified for interlocutory appeal the cases of nontest case
petitioners represented by Izen, Jones, and Sticht who had also.
participated in the evidentiary hearing and nontest case
petitioners represented by O'Donnell whose cases were the subject
of the Court's opinion in Gridley v. Commissioner, T.C. memo.
1997-210.
C.
These nontes.t case petitioners also appealed.
The Ninth Circuit's Opinion and
Mandates in These Cases
On November 21, 2001, following extensive motion practice on
jurisdiction and other issues, the Court of Appeals set a
briefing schedule and confirmed that the cases on appeal would be
scheduled before the panel that issued the DuFresne opinion.
Following receipt of opening and reply briefs from test case
- 64 petitioners,27 now represented by. three sets of attorneys,28 the
DuFresne panel filed an order indicating that, upon
reconsideration,. it would not retain jurisdiction, and directing
the Clerk to schedule the appeal in the normal course of events.
On October 10, 2002, the panel that ultimately issued the opinion
in Dixon V heard oral argument in the test cases.
On January 17, 2003, the Court of Appeals issued its opinion
in the test cases in Dixon v. Commissioner, 316 F.3d Í041
(9th
Cir. 2003), amended on March 18, 2003 (Dixon V), vacating and
remanding the Court's decisions in the test cases, and directing
the further proceedings that have resulted in this opinion.
Citing Hazel-Atlas Glass Co. v. Hartford-Empire Co., 322 U.S.
238, 247 (1944), overruled on other grounds Standard Oil v.
United States, 429 U.S. 17,
stated:.
18
(1976), the Court of Appeals
"There can be no question here but that the actions of
McWade and Sims amounted to a fraud on both the taxpayers and the
Tax Court."
Dixon v. Commissioner, 316 F.3d at 1046.
The Court
270n Nov. 20, 2001, the DuFresne panel had filed an order
directing that the appeals of nontest case petitioners
represented by Izen, Sticht, Jones, and O'Donnell "shall be held
in abeyance.pending resolution of the appeal in No. 00-70858"
(i.e., the test cases).
28The three sets of attorneys are Izen, Michael L. Minns,
and John A. Irvine and Henry G. Binder.
- 65 of Appeals held that "fraud on the court" occurs regardless of
whether the opposing party is prejudiced.
Id.29
The Court of Appeals further stated:
We have the inherent power to vacate the judgment
of the Tax Court, fashion an apprópriate remedy, and
sanction a party or its lawyers for willful abuse of
the judicial process, particularly when the party or
its lawyers have intentionally practiced a fraud upon
the Court. * * *
* * * The taxpayers should not be forced to endure
another trial and.the IRS should be sanctioned for this
extreme misconduct.
Conversely, we will not enter judgment eradicating
all tax liability of these taxpayers.
Such an extreme
sanction, while within the court's power, is not
warranted under these facts. *.* *
Id. at 1047 (citations omitted).
The Court of Appeals instead
reversed the decisions of this Court in the test cases and
directed this Court to "enter judgment in favor of Appellants and
all other taxpayers properly before this Court on terms
equivalent to those provided in the settlement agreement with
Thomps.on and the IRS."
Id.
It 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.
29The Court of Appeals acknowledged the contrary holding of
the Court of Appeals for the Seventh Circuit in Drobny v.
Commissioner, 113 F.3d 670 (7th Cir. 1997), affg. T.C. Memo.
1995-209.
In Drobny, the Seventh Circuit held that proof of
fraud on the court requires a showing that the alleged misconduct
actually affected the outcome oof the case to the taxpayer's
detriment. Id. at 678-679.
- 66 On January 21, 2003, respondent's then Chief Counsel,
referring to Dixon V, publicly announced:
"We will * * * assure
that no interest is charged on deficiencies for the period of the
appeals to the Ñinth Circuit."3°
On February 3, 2003, Deborah Butler, respondent's Associate
Chief Counsel for Procedure and Administration, issued a Chief
Counsel notice (CC-2003-008), reminding all Chief Counsel
attorneys, in light of the opinion of the Court of Appeals in
Dixon V, "to adhere to the highest ethical standards when
performing their duties, including when representing the IRS
before the Tax Court."
On March 14, 2003, the Court of Appeals issued orders
remanding to the Tax Court for further proceedings consistent
with the opinion in Dixon V the nontest cases that had been
appealed pursuant to their certification for interlocutory
appeal.
On April 23, 2003, the Court of Appeals issued its
mandates with respect to the test cases in accordance with Dixon
V.
D.
Proceedings Following Remand
On April 30, 2003, respondent filed a motion for a status
conference regarding disposition on remand of the test cases and
a group of related nontest cases.
On May 1, 2003, this Court
3°The original decisions in Dixon II were entered Mar. 13,
1992; the notices of appeal were filed May 14, 1992; the 90-day
appeal period would have expired June 11, 1992.
- 67 ordered the parties to file status reports regarding subsequent
disposition of the cases.
The responses displayed various
disagreements between respondent and petitioners concerning not
only the scope of the remedy, but the manner of its
implementation.
For example, the status report of petitioners'
counsel Henry Binder states:
"Respondent does not come to this
Court's fashioning of the equitable remedy ordered by the Ninth
Circuit with clean hands and, therefore, has no standing to argue
the terms or scope of that remedy."3¹
The Court conducted status
conferences in Houston, Texas, in August 2003 and in Los Angeles,
California, in September 2003 to address petitioners' attempts to
settle the cases.
The conferences resulted.in no settlement.
The parties then engaged in.protracted motions practice
regarding assertions of privilege by respondent as to some
matters sought in discovery and regarding the award of attorney's
.fees claimed by counsel for petitioners.
On April 5, 2004, petitioners filed motions for an
evidentiary hearing.
Thereafter, at the behest of the parties,
the Court directed further discovery and conducted further
hearings.
The first hearing took place at Las Vegas, Nevada, in
3¹Having considered certain issues raised in the status
reports, this Court issued an order dated June 12, 2003,
indicating it was "not inclined to consider attempts to
disqualify counsel" in any of the cases at issue. We
additionally stated:
"This Court is not inclined to seek
appointment of counsel from the United States Department of
Justice to represent respondent.in these cases".
- 68 September 2004, the second hearing at Los Angeles, California, in
November 2004, and the final hearing at Washington, D.C., in
March 2005.
By the end of September 2005, the parties had filed
their briefs regarding the scope and application of the Thompson
settlement.
E.
Further Disciplinary Proceedings
On April 1, 1999, the day immediately. following the issuance
of the Dixon III opinion, Judge Beghe referred the misconduct of
Sims, McWade, and DeCastro to the Committee on Admissions,
Ethics, and Discipline of the Tax Court for disciplinary
action.32
In accordance with the Court's practice in such
matters,
the referrals were not mentioned in the Dixon III
opinion or otherwise publicized when that opinion was issued.
On April 22, 2003, the Court, through the Committee on
Admissions, Ethics, and Discipline, issued orders to Sims,
McWade, and DeCastro to show cause why they should not be
suspended or disbarred from practice before the Court or
otherwise further disciplined.
On July 1, 2003, DeCastro
resigned from practice before the Court.
32On June 26, 1996, at what then seemed to be the close of
the evidentiary hearing, Izen had filed a motion requesting this
Court to re'fer the Thompson and Cravens settlements and McWade's
settlement with Denis Alexander to the DOJ (Public Integrity
Section) for criminal prosecution.
Izen identified approximately
17 alleged crimes associated with these settlements.
By order
dated June 26, 1996, the Court denied Izen's motion.
- 69 Following complaints filed by petitioners' counsel Minns in
response to inquiries by the Dixon V panel at oral argument, the
Arkansas State Bar suspended Sims's license to practice for 1
year in February 2004, and the Oregon State Bar suspended
McWade's license to practice for 2 years in August 2004.
This
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 for 2 years, commencing February
20, 2004.33
The Director of the IRS Office of Professional
Responsibility suspended McNade and Sims indefinitely from
practice before the IRS, effective June 9, 2004.
Under Rule 202(c)(1), a practitioner who has been suspended
for more than 60 days or disbarred from practice before this
Court may not resume practice until reinstated by order of the
Court.
Under Rule 202(c)(2),
if the disciplinary proceeding
giving rise to a suspension or disbarment was predicated upon the
complaint of a Judge of this Court, a hearing on the petition for
.reinstatement is to be held before a panel of three other Judges
appointed by the Chief Judge.
At the hearing on the petition:
the practitioner shall have the burden of demonstrating
by clear and convincing evidence that the practitioner
33The first announcement by the Court with respect to the
referrals was the Court's issuance, on Feb. 20, 2004, of a press
release that disciplinary action had been taken against McWade
and Sims.
DeCastro's resignation was not publicized by the Court
until issuance of the opinion herein.
- 70 has the moral qualificatiöns, competency, .and learning
in the law required for admission to practice before
this Court and that the practitioner's resumption of
such practice will not be detrimental to the integrity
and standing of the Bar or to the administration of
justice, or subversive of the public interest..
[Id.]
OPINION
Preliminary Comments
The Court of Appeals has directed that the remaining test
case petitioners "and all other taxpayers properly before this
Court" receive judgments in their favor "on terms equivalent to
those provided in the settlement agreement with Thompson and the
IRS."
Dixon v. Commissioner, 316 F.3d at 1047.
The Court of
Appeals has left to this 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 in
the Thompson settlement."
Id. n.11.
Throughout the proceedings.required to implement the
mandates of the Court of Appeals, petitioners, impelled by
outrage and indignation at the fraud on the Court committed by
respondent's attorneys, seem to view the mandates as an
invitation to award damages against respondent.
Without in any
way minimizing the seriousness of the misconduct of respondent's
attorneys, we decline any such invitation.34
The mandates do not
call for the recovery of damages by the taxpayers; they call for
3dIn any event, we lack jurisdiction to award damages.
Chocallo v. Commissioner, T.C. Memo. 2004-152.
- 71 sanctions against respondent, to be determined in accordance with
the ascertainable standard provided by the Dixon V opinion.
We now broach how, in light of the different circumstances
of the Thompsons and the various groups of affected taxpayers, we
can follow and apply the directive of the mandates.
Interpreting
the term "same position" used in footnote 11 of Dixon V to mean
"same financial position", it might seem, at first blush, that
the test case and nontest petitioners cannot be put in the
financial position the Thompsons found themselves in as a result
of the Thompson settlement.
The Thompson settlement was embodied
in a sequence of payments and refunds that occurred more than 15
to 20 years ago, when personal interest was fully or partially
deductible for income tax purposes, in a different interest rate
environment, and in temporal relationships that are not now
reproducible with respect to any of the other petitioner
participants in the Kersting project.
Also, the bulk of those
.refunds was used to pay legal fees the other test case
petitioners were not required to pay for representation in the
test case trial.
It should be borne in mind that the Thompson settlement
occurred in two distinct phases:
In December 1986 into early
1987, McWade and DeCastro arranged to provide the Thompsons a
reduction of approximately 20 percent in the originally
determined.deficiencies; this version of the settlement took
- 72 account of respondent's increased litigation risk resulting from
Chicoine and Hallett's efforts to suppress the evidence
discovered in- the IRS raid on Kersting's office.
Other Kersting
petitioner clients of DeCastro and Chicoine and Hallett obtained
20-percent reduction -settlements from McWade prior to the Court's
1988 opinion in Dixon I, and some other nontest case petitioners
thereafter obtained such settlements.
.The Thompsons' payments to
the IRS in late 1986 and in 1987 were made to satisfy their
obligations under the approximately 20-percent reduction
settlement arranged by McWade and DeCastro.
DeCastro thereafter played on the fears of Sims and McWade
that he would walk away from the test case trial to extort the
additional reduction agreed to in late 1988 and early 1989 that
would generate the refunds that were to be used to pay his fees
for providing legal representation to the Thompsons at the trial.
The new Thompson settlement had no rationale quantifiably related
to the hazards of litigation or the merits of the case; it was
based on the opportunistic estimates of McWade and Decastro of
what was needed to bring about a particular financial result that
has little or no congruence with the situation in which the
petitioners before the Court now find themselves.
The fact that
the Thompsons had already made the payments required by the
earlier 20-percent reduction settlement provided the fund that
was ripening for the taking under the new settlement.
As it
-
73
-
.
turned out, the overall reduction of approximately 62 percent in
the Thompson deficiencies provided by the new settlement was more
than -enough to produce the approximately $60,000 of refunds
McWade and.DeCastro thought would be needed to pay DeCastro's
original estimate of what his fees would be.
As it further
turned out, the additional interest .on the Thompsons' payments
under the original settlement was sufficient to provide DeCastro
with an additional fee that he (and perhaps Mr. Thompson)
probably felt was justified by his success in keeping the new
settlement in effect, as well as leave a surplus to be retained
by the Thompsons.35
Test case and nontest case petitioners in the main fall into
two groups, both of which are now in different situations from
the situation of the Thompsons 15-20 years ago.
It is the
Court's impression that a substantial majority of nontest case
petitioners are in the unhappy situation of having followed
Kersting's advice to stand pat.
They neither settled their cases
nor made any remittances in respect of the deficiencies
determined against them.
With the passage of years and the
operation against them of the force of compound interest, they
claim that they have been facing financial ruin, with all its
35The lack of legal rationale and the opportunistic
character of the new settlement are emphasized by the fact that
it was entered into after the litigation risk·that supported the
original 20-percent reduction settlement had evaporated with the
publication of this Court's opinion in Dixon I.
- 74 attendant anxieties; this is because they did not have the
foresight or the discipline to invest the chimerical tax savings
they had appropriated by. using the Kersting shelters to support
their original return positions.36
On the other hand, there are
a minority of petitioners who, without conceding their
liabilities, have stopped the running of interest against
themselves by prepaying the Kersting deficiencies the IRS had
determined against them."
With the passage of time and the
operation in their favor of the force of compound interest, this
minority of petitioners .are entitled, under the Dixon V opinion
and mandates, to substantial refunds, and properly so.
A further comment:
The financial burden of petitioners who
did not prepay has been substantially ameliorated--but not
completely eliminated--by respondent's concession that no
interest will be charged on deficiencies for the period of the
36The bulk of.petitioners in the Kersting project appear to
have been commercial airline pilots.
There is no evidence in the
record of their financial sophistication or lack thereof, either
individually or as a group..
"The Court understands that this group includes the
remaining test case petitioners, with the exception of the
Dixons, who received a discharge in bankruptcy. By collecting
the deficiencies from the test case petitioners because of their
failure to file appeal bonds, cf. Estate of Kanter v.
Commissioner, T.C. Memo. 2006-46, respondent has put those
petitioners in the advantageous position of being entitled to
collect substantial refunds, on which interest has been accruing
and compounding.over .the years without attracting current annual
tax liabilities. Of course, the interest component of those
refunds will be includable in gross income of the recipients when
finally paid.
e
- 75 appeals to the Ninth Circuit.
That concession, prompted by
respondent's recognition of responsibility for the delay in
resolving the Kersting project cases caused by the need to
investigate the misconduct of respondent's attorneys,.seems
appropriate, but also geherous.
Even if there had been no
misconduct by respondent's at.torneys, the appeals filed by test
case petitioners, before the misconduct was discovered, would
have taken some substantial time beyond June 1992 to resolve.
The amelioration is substantial because it has stopped the
further accrual and compounding of interest on the deficiencies
for more than 13 years.
The amelioration is not complete because
many petitioners have deficiencies going back to the late 1970s
and early 1980s.
The bottom line is that, in the absence of the misconduct,
petitioners who did not prepay would have been required to pay
substantially more than they will be required to pay under the
mandates.
Moreover, they will be entitled to pay these reduced
amounts many years later than would have been necessary if there
had been no misconduct.
As a result of respondent's concession,
they have had the use of the money due for their reduced
deficiencies for more than 13 additional years.
Stated
differently, t'hey have enjoyed for more than 13 years the
equivalent of an interest-free loan of the reduced deficiencies
and interest they will now have to pay.
- 76 In sum, this Court has determined the terms of the Thompson
settlement.
Our decisions in these cases will apply those terms
to test case and nontest case petitioners alike. . Subject to the
review of the Court of Appeals, our opinion and decisions will
provide the template for the disposition of the more than 1,300
pending cases in the Kersting project.
The thoughts underlying the foregoing comments have informed
our effort not only to determine and apply the terms of the
Thompson settlement, but also our effort to put petitioners, to
the extent possible and practicable, in positions similar to that
provided by the Thompson settlement.
Although it may be
impossible to.put petitioners in the same position, financial or
otherwise, the Thompsons were in 15 to 20 years ago, we observe
that the Code provisions for interest on deficiencies and
overpayments,38 in which are embedded the time value of money
principles that underlie all financial planning," provide the
only available appropriate means of approximating the desired
equivalence."
38Secs. 6601,
6611.
"See generall.y, e.g., Brealey & Myers, Principles of
Corporate Finance (7th ed. 2003).
"Gokhale & Smetters, "Measuring Social Security's Financial
Outlook within an Aging Society", Daedalus 91-92 n.2 (Winter
2006), comment that discounting to present value, an operation
integral to giving effect to the time value of money, makes it
possible "to place dollars accruing at different points in time
(continued...)
- 77 For two reasons, those petitioners who prepaid will receive
refunds many times greater than the Thompsons received:
Most of
those petitioners probably made payments equal to their
originally determined deficiencies, not just 80 percent thereof,
like the Thompsons, and their refunds will be exponentially
increased by interest accruals because they have had to wait.much
longer.than the Thompsons did to receive their refunds.
On the other hand, those petitioners who, unlike the
Thompsons, did not prepay will have deficiencies .that will be .
reduced in the same proportion as the Thompsons' deficiencies
were finally reduced under the settlement.
Although they wi.ll
still have to pay those reduced deficiencies with interest
accruing until mid-1992, their interest obligation will have been
substantially reduced by respondent's concession.
We conclude
these comments by again observing that these petitioners will
still be substantially better off financially than they would
have been in the absence of respondent's.misconduct.
And so
should it be, in accord with the sanction the Court of Appeals
has fixed as the appropriate judicial response to the misconduct
of respondent's attorneys.
4°(...continued)
on an equal valuation scale".
- 78 I.
Procedural Issues Following Remand
A.
Procedural Posture
These cases are before the Court pursuant to the DuFresne
and Dixon V opinions and mandates of the Court of Appeals for the
Ninth Circuit.
They therefore present issues in a procedural
posture diametrically different from the standpoint from which we
usually redetermine income tax deficiencies or overpayments
arising from notices of deficiency or refund claims.
Here, the
traditional roles of petitioner and respondent are reversed.
In
this phase of the proceedings, it is respondent, not petitioner,
whose activities are being questioned.
It is respondent, not
petitioners, who is charged with having the necessary ·records and
the personnel who have recollections regarding the matters at
issue."
Because of the unique posture of this case, it is
respondent, not petitioner, who often argues that a deduction has
been properly claimed and allowed (and thus should not be
included as one of the taxpayer benefits of the Thompson
settlement), while petitioners argue the .contrary.
"It should be noted that, following the remand in Dixon V,
neither side called DeCastro, Mcwade, or Sims as a witness. We
understand that DeCastro is seriously ill, so he was not
available. We have no such information about McWade or Sims;
perhaps their previous failures to persuade this Court of their
credibility discouraged both sides from calling them.
- 79 B..
Law of the Case
The Court of Appeals for the Ninth Circuit recently
explained the law of the case doctrine as follows:
"The law of the case doctrine requires a district
court to follow the appellate. court's resolution of an
issue of law in all subsequent proceedings in the same
case." United States ex rel. Luian v. Hughes Aircraft
Co , 243 F.3d 1181, 1186 (9th Cir. 2001) .
The doctrine
applies to both .the appellate court's "explicit
decisions as well as those issues decided by necessary
implication." United States v. Cote, 51 F.3d 178, 181
(9th Cir. 1995) (quoting Eichman v. Fotomat Corp., 880
F.2d 149, 157 (9th Cir. 1989)). * * *
[Al-Safin v.
Circuit City Stores, Inc., 394 F.3d 1254, 1258 (9th
Cir. 2005).]
In relying upon its inherent authority to sanction the IRS by
extending the benefit of the Thompson settlement to all
interested parties, the Court of Appeals by necessary implication
concluded that the doctrine of inherent authority trumps the
doctrine of sovereign immunity (the latter generally prohibiting
the imposition of monetary sanctions against the United States
absent the express consent of Congress).42
We therefore are not
concerned with that issue.
42The principle that a court has inherent power to impose
sanctions is well established.
"It has long been understood that
'[c]ertain implied powers must necessarily result to our Courts
of justice from the nature of their institution,' powers 'which
cannot be dispensed with in a Court, because they are necessary
to the exercise of all others.'" Chambers v. NASCO, 501 U.S. 32,
43 (1991) (quoting United States v. Hudson, 11 U.S. (7 Cranch)
32, 34 (1812)).
- 80 C.
Parties Before the Court
The opinion of the Court of Appeals directs this Court "to
enter judgment in favor of Appellants and all other taxpayers
properly before this Court".
1047.
Dixon v. Commissioner, 316 F.3d at
In a technical sense, the Dixon V opinion and the
implementing mandates might be deemed to extend only to those
parties who filed notices of appeal.
859 F.2d 115,
120 (9th Cir.
1988).
See Abatti v. Commissioner,
We believe, however, that the
Court of Appeals did not intend a technical, restricted
application of its opinion and mandates, nor, apparently, do the
parties.
Following the hearings in these cases, the parties
filed a stipulation of settled issues.
Among other things, that
stipulation recites:
1.
The Kersting deficiencies of any petitioner
who has filed a piggyback agreement with the Tax Court
shall be determined in accord with the Ninth Circuit's
mandates as implemented by the Tax Court on remand in
this proceeding * * *.
2.
The Kersting deficiencies of any petitioner
in a case docketed before the Tax Court who has not
filed a piggyback agreement will, absent a showing of
cause, be determined in accord with the Ninth Circuit's
mandates as implemented by the Tax Court on remand in
this proceeding * * *.
We read these stipulations to apply to all open cases of
petitioner participants in the Kersting tax shelter programs.
other words, the parties have agreed--and properly so--that the
sanction applies to benefit not only to test case petitioners,
but also to nontest case petitioners in all remaining docketed
In
- 81 cases in the Kersting project, whether or not they signed
piggyback agreements.
D.
Burden of Proof
In our Dixon III opinion, we noted several factors that
impelled us to impose the burden uaf proof on respondent with
respect to whether the misconduct of respondent's attorneys
resulted in a fundamental defect or in harmless error.
Those
same factors apply to the present proceedings concerning the
scope and application of the Thompson settlement.
As in Dixón
III, respondent has had.direct and immediate access to the
critical witnesses and most of the relevant documents since May
1992, when the misconduct of respondent's attorneys first came to
light.
Further, respondent conducted an internal investigation
of that misconduct, without the participation of outside parties,
soon after discovering the misconduct.
Petitioners, on the other
hand, have had to rely on discovery and circumstantial evidence,
plus whatever evidence respondent has revealed voluntarily.
Petitioners have .been far less favorably situated than respondent
to produce the factual record needed to decide these cases on
remand.
Furthermore, and finally, as we have previously
observed, these cases are not in the normal deficiency posture,
and it is the.misconduct of respondent's attorneys that is under
review.
Accordingly, we again conclude that the interests of
justice are better served by placing the ultimate burden of proof
- 82 and persuasion on respondent, and we so hold.43
See Rockwell v.
Commissioner, 512 F.2d 882, 885-887 (9th Cir. 1975), affg. T.C.
Memo. 1972-133.
We recognize that.imposing the burden of proof on respondent
may put respondent in the difficult position of having to prove a
negative; i.e., that a given outcome or transaction involving the
Thompsons was not a result of the Thompson settlement.
In other
circumstances, when a taxpayer has the burden of proving the
negative of a proposition, such as proving the nonreceipt of
income, the Court.of Appeals for the Ninth Circuit requires the
Commissioner to produce at least some substantive evidence
linking the taxpayer to the income-producing activity.
See
Weimerskirch v. Commissioner, 596 F.2d.358, 361 (.9th.Cir. 1979)
(respondent must offer "some foundational support" of the receipt
of such income), revg. 67 T.C. 672 (1977).
Accordingly, in the
matter at hand, it is appropriate to require petitioners to
43Petitioners have filed a motion, as supplemented by a
later motion, asking the Court to assign the burden of proof to
respondent on 22 specified issues; in so doing, petitioners aver
that they do not seek a general allocation of the burden of proof
to respondent.
Respondent has objected to these motions, quoting
Kluger v. Commissioner, 83 T.C. 309, 310 n.1 (1984), for the
proposition that the Court "has neVer, in any context, invoked
such a sanction".
Our action in Dixon III in shifting the
042
general burden of proof and persuasion to respondent in that
phase of these proceedings belies respondent's objections. We
have concluded that no useful purpose would be served by
addressing petitioners' motions on an issue-by-issue basis.
Suffice to say we have assigned the burden of proof and
persuasion to respondent on each issue of fact that bears on the
scope and terms of the Thompson settlement.
- 83 produce at least some substantive evidence indicating that
asserted benefits to the Thompsons are the result of the Thompson
settlement, at least when respondent is in the position of having
to prove the contrary.
In this regard, it is appropriate for
petitioners to rely upon circumstantial evidence, although 'here,
as in other contexts, "'mere suspicion or speculation does not
rise to the level of sufficient evidence'".
See United States v.
Dinkane, 17 F.3d 1192, 1196 (9th Cir. 1994)
(quoting United
States v. Stauffer,
922 F.2d 508,
514
(9th Cir. 1990)).
Finally, we believe the factual issues regarding the
r
operative terms and scope of the Thompson settlement, now that
the existence and overall significance of the misconduct have
been determined, do not present policy considerations that
require a heightened standard of proof, such as the requirement
of "clear and convincing" proof of fraud imposed by our Rule
042
142(b) in deficiency cases, that we applied in Dixon III against
respondent in an earlier phase of these proceedings.
Accordingly, we hold that the quantum or level of respondent's
burden is a "preponderance" of the evidence, the traditional
quantum or level of proof required under Rule 142(a) and the case
law thereunder."
This is the same standard to which we and
"Petitioners have not sought to allocate the burden of
proof to respondent on the ultimate question of whether the
Thomson settlement is characterized as a 20-percent reduction in
deficiencies, plus the payment of the Thompsons' legal fees, or
(continued...)
- 84 other courts have,
for many years, held taxpayers on questions of
general tax liability, and we believe that this is the
appropriate standard to apply to respondent in this phase of the
proceedings.
See Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933); Am. Pipe & Steel Corp. v. Commissioner, 243 F.2d 125,
126-127 (9th Cir. 1957), affg. 25 T.C. 351 (1955).
II.
Defining and Applying the Thompson Settlement
A.
Overview
.
In Al-Safin v. Circuit City Stores, Inc., 394 F.3d at 1258,
the Court of Appeals reminded us that its opinion may be
consulted to ascertain what was intended by the mandates.
In
Dixon V, the Court of Appeals described the basis of the "secret
settlement agreements" with the Thompsons and the Cravenses as
follows:
"A condition of their settlements required Thompson and
Cravens to remain test case petitioners. * * * With respect to
Thompson, McWade agreed to have Thompson's tax deficiencies
reduced in proportion to his attorney's fees, which exceeded
$60,000."
Dixon v. Commissioner, 316 F.3d at 1044; fn. ref.
44(...continued)
as a 62-percent reduction.
See Part C, infra. We observe that
the significant evidentiary facts on this issue are not in
dispute, so that the burden of proof does not enter into what we
see as a problem of legal characterization.
Therefore, the
question does not arise whether we should employ some heightened
standard of proof, such as "strong proof" or "clear and
convincing" proof, that might otherwise arise when a party to ·a
transaction seeks to disregard the form employed.
Our resolution
of this issue does not depend on the allocation or standard of
the burden of proof.
- 85 omitted.
The Court of Appeals further described the Thompson
settlement as a "vehicle for paying Thompson's attorney's fees",
notwithstanding McWade's testimony that the settlement "was
attributable to a separate transaction."
Id. at 1045."
The opinion of the Court of Appeals displays its
understanding that the Thompson settlement was a covert
transaction, a "secret settlement agreement" that "was a vehicle"
to provide the Thompsons with advantages--including payment of
attorney's fees through a drastic reduction of deficiencies, and
elimination of Kersting and non-Kersting additions--over and
above those offered to other taxpayers.
Thus, while our sanction
should put the other affected taxpayers in the position of having
received the benefits the Thompsons received, those benefits
should be fairly traceable to the sanctionable conduct of
respondent's counsel, McWade and Sims.
As we informed the
parties in an order dated February 28, 2005:
"The reference to a "separate transaction" is to the
Thompsons' participation in the Bauspar program.
In his brief to
the Court of Appeals, Izen explained that McWade and Sims had
misled this Court by "denying that the Thompsons [sic] settlement
was a vehicle for paying DeCastro's legal fees for representing
the Thompsons at the trial of the test cases, [and] by testifying
that the Thompsons [sic] settlement was attributable to the
Thompsons' participation in the Bauspar program."
Additionally,
as we observed in Dixon III, "Mr. McWade testified that the
Thompsons' settlement was revised in the summer of 1989 in order
to dispose of the Bauspar issue. Mr. McWade denied that the
Thompsons'·settlement was revised to provide a means for the
Thompsons to pay Mr. DeCastro's attorney's fees."
- 86 The mere fact that the Thompsons received a tax benefit
is insufficient to enable the Court to conclude that
the benefit was part of the settlement. With respect
to each item, it is also necessary to show, or find it
appropriate to assume, that respondent's counsel played
an enabling or facilitating role in procuring or
assuring the benefit to. the Thompsons.
B.
Areas of Agreement
The parties' stipulation of settled issues, in addition to
delineating the beneficiaries of the Court of Appeals' mandates,
see supra Part I.C., establishes some common ground regarding the
relief to which those beneficiaries are entitled:
3.
The "burnout" element of the Thompson
settlement is as follows:
(a)
for taxpayers with 2-3 taxable. years
before the court, the first year's
deficiencies are shifted forward and
combined with the deficiencies in the
second year then reduced in accord with
the Ninth Circuit's mandate; and
(b)
for taxpayers with 4 or more taxable
years before the court, the first year's
deficiencies are shifted forward to the
second year and the second year's
deficiencies are shifted forward and
combined with the deficiencies in the
third year, after which all deficienci.es
are reduced in accord with the Ninth
Circuit's mandate.
4. No petitioner will incur any penalties
stemming from such petitioners's [sic] Kersting
deficiencies.
- 87 We incorporate the foregoing stipulations in the relief we
announce today."
As for the deficiencies themselves, petitioners and
respondent have agreed that the originally determined Kersting
deficiencies should be reduced in proportion to the monetary
benefit the Thompsons received as a result of the new agreement
between McWade and DeCas-tro.
As petitioners explain: "To
determine a percentage reduction of aggregate deficiencies
requires a numerator and denominator, the numerator being the
amount the Thompsons actually paid under the settlement and the
denominator being the amount they would have paid absent the
settlement."47
We agree, with the initial caveat that, inasmuch
as the parties address both interest and Kersting-related
penalties elsewhere, we. disregard those items in determining what
the Thompsons paid (the numerator) and would have paid (the
denominator).
"We do not adopt all aspects of the parties' stipulation of
.settled issues.
See infra note 67.
47Actually, the resulting percentage would represent the
proportion of proposéd deficiencies that affected taxpayers would
be required to pay.
To obtain the "percentage reduction" it will
be necessary to subtract the percentage so found from 100
percent.
- 88 C.
Starting Point:
The Thompsons' Settlement
of Proposed Deficiencies for 1979-1981
1.
Respondent's Position
Respondent's characterization of the Thompsons' settlement
of their 1979-1981 deficiencies, as set forth in a status report
dated May 28, 2003, has·remained constant throughout the
proceedings on remand from Dixon V.
Respondent maintains,
"from
a substantive standpoint", that the Thompsons' settlement of
their 1979-1981 deficiencies "amounted to a 20% reduction of the
deficiencies"48 plus "payment of the Thompsons' attorney's fees
incurred with respect to the actual trial of the test cases
resulting in the opinion in Dixon v. Commissioner, T.C. Memo.
1991-614
(Dixon II)."
In other words, respondent maintains that
the settlement fraction numerator--"the amount the Thompsons
actually paid under the settlement"--is $63,000 (the amount of
tax the Thompsons remitted to the IRS in June 1987).
In
respondent's view, the settlement should not reflect the
additional $33,000 reduction in tax plus the accompanying
interest reductions that generated the refunds of $30,000 in July
1989 and $32,250 in February 1993" that were signed over to
DeCastro, nor the interest refunds on the resulting overpayments
48More accurately, 20.55 percent (from $79,294 to $63,000).
"Respondent applied the remaining $750 to the Thompsons'
1988 tax year.
- 89 that funded an additional fee payment to Decastro later in 1993
and still left over something that was retained by the Thompsons.
Respondent argues that, because none of the other
petitioners (test case or nontest case)
incurred attorney's fees
for the test case trial (all such fees were paid by Kersting),
those petitioners would receive an economic windfall if we were
to use the actual 62-percent reduction in the Thompsons'
1979-
1981 deficiencies as the starting point for our remedy.
.Respondent reasons that the 62-percent characterization would
provide a benefit to petitioners
(the reduction in their proposed
deficiencies by an additional 42 percent) that the Thompsons did
not enjoy due to their implicit obligation to turn over the bulk
of the resulting refunds to DeCastro as payment for legal
services that conferred no discernible benefit to them.
Respondent further argues that the relatively small portion of
9
the refunds of tax and interest ultimately retained by the
Thompsons
($17,224.61 out of $98,449.61) is rendered even more
insignificant by the fact that the Thompsons reported almást
twice that amount ($33,966.68) as gross interest income received
from the IRS in 1993 on which they paid tax.5°
In sum,
respondent argues, the sweetener embodied in the final settlement
5° Respondent overlooks the fact that the refunds of
$33,966.68 of taxable interest income reported by the Thompsons
for 1993 were substantially exceeded by the $51,000 deduction for
legal fees claimed by and allowed to them for that year.
- 90 that was achieved by increasing the deficiency reduction
percentage from 20 percent to 62 percent in effect should be
disregarded because the refunds generated thereby purchased
nothing of value and provided at most a de minimis increase in
the Thompsons' net worth.5¹
2.
Petitibners' Position
In sharp contrast, petitioners view the Thompsons'
settlement of their 1979-1981 deficiencies strictly in terms of
the percentage reduction in the total amount of tax the Thompsons
were required to pay.
Thus, petitioners maintain that the
starting point for determining the percentage reduction in
deficiencies to which they are entitled is 62.17 percent,
representing the final total reduction of the Thompsons' proposed
deficiencies for the years at issue from $79,294 to $30,000.
In addition to their argument that the form of·the
Thompsons' settlement of their 1979-1981 deficiencies (62.17percent reduction) provides the starting point for determining
the appropriate sanction in these cases, petitioners dispute
respondent's assertion that the payment of DeCastro's fees was
s¹A more nuanced adoption and application,of respondent's
argument might arrive at some percentage between 20 percent and
62 percent by increasing the 20 percent to reflect the amount of
the refunds actually retained by the Thompsons or the amount they
expected or were expected to retain after their endorsement over
to DeCastro of the first two refunds.
Neither side has advanced
such an argument.
- 91 one of the substantive elements of that settlement.
Petitioners
urge tlat the evidence does not support a finding that the
Thompsons' use of the refunds generated by the final reduction in
deficiencies was restricted in any way.
They point to some
inconsistencies in the estimate of total fees that DeCastro had
given to McWade, as well as DeCastro's initial reluctance to
acknowledge that respondent had arranged to pay his fees.
Accordingly, petitioners argue that the substance of the
Thompsons' settlement of their 1979-1981 deficiencies did not
depart from the form in which respondent provided it--that is/ a
reduction of 62.17 percent in the deficiencies originally
determined for those years..
3.
Analysis
As a threshold matter, we do not believe that the
inconsistencies perceived by petitioners outweigh the direct and
042
circumstantial evidence that, in substance, the Thompsons'
settlement of their 1979-1981 deficiencies was, in the words of
the Court of Appeals, a "vehicle for paying Thompson's attorneys'
fees".
The preponderance of the evidence shows that, when they
made their final deal, McWade and DeCastro intended that the
refunds generated by the final reduction of the Thompsons'
deficiencies would go to DeCastro in payment of his fees.
The
fact that the Thompsons endorsed the first two refunds--two
checks totaling $62,225--directly to DeCastro's law firm confirms
- 92 that intention.
In a telephone call with Bakutes on June 10,
1992, DeCastro himself conceded that the refunds were intended as
a means of paying his fees.
Although we recognize that the payment of DeCastro's fees
was an essential element of the Thompsons'
settlement of their
1979-1981 deficiencies, it does not follow that respondent's
characterization of that settlement (20-percent reduction in
deficiencies plus payment of attorney's fees) must prevail.
From
a practical standpoint, respondent overlooks the fact that the
refunds generated by the ·reduction in deficiencies exceeded the
legal fees they were intended to defray.
More importantly,
inasmuch as the Court of Appeals has taken us to task for twice
failing "to equitably resolve" a situation in which respondent's
attorneys committed fraud on the court, we believe respondent
should be held to the form of the new settlement.
That is, we do
not think it appropriate to define the Thompsons' settlement of
their 1979-1981 deficiencies only by reference to its asserted
substance, which would require respondent to reduce the proposed
deficiencies of the affected taxpayers by only 20 percent (this
would be the practical effect, because, although respondent would
also be required to reimburse the affected taxpayers for
attorney's fees, none of the affected taxpayers paid any such
- 93 fees).52
We instead think it appropriate to hold respondent to
the form of the transaction adopted by his misbehaving attorneys,
i.e., the reduction of the Thompsons' 1979-1981 deficiencies by
62.17 percent, without regard to the fact that the Thompsons used
the bulk of the refunds generated thereby to pay DeCastro's fees.
We recognize that, in the usúal case, it is taxpayers who
are held to the form of the transaction they have adopted; once a
party has chosen to organize his affairs in a certain fashion,
"he must accept the tax consequences of his choice, whether
contemplated or not * * * and may not enjoy the benefit of some
other route he might have chosen to follow but did not."
Commissioner v. Natl. Alfalfa Dehydrating & Milling Co.,
134, 149 (1974).
417 U.S.
On the other hand, respondent generally may
disregard the taxpayer's form, and, if that form is "unreal or a
sham may sustain or disregard the effect of the fiction as best
serves the purposes of the tax statute."
U.S. 473,
477
(1940).
Hiqqins v. Smith,
308
We also recognize that, in these cases,
the traditional roles of petitióner and respondent have been
reversed.
Requiring respondent to assume the procedural posture
of a taxpayer does not necessarily prohibit respondent from
asserting substance over form.
We have in mind the following
32The attorney's fees incurred by petitioners for which
respondent may be liable relate to further proceedings required
by the misconduct of respondent's attorneys and are in no way
analogous to the Thompsons' fees to DeCastro for his
representation in the original trial in Dixon II.
- 94 comment of Judge Wisdom:
"The taxpayer too has a right to assert
the priority of substance--at least in a case where his tax
reporting and actions show an honest and consistent respect for
the substance of a transaction."
Weinert v. Commissioner, 294
F.2d 750, 755 (5th Cir. 1961), affg. 31 T.C. 918 (1959).53
Our difficulty with respondent's assertion of the "priority
of substance" arises from the failure of respondent's actions to
show "an honest and consistent respect for the substance of [the]
transaction."
Here, respondent, through his former attorneys,
did not shöw respect for the substance of the transaction.
McWade and Sims.tried to hide the settlement from their.
supervisors,
from the other parties, and from the Court.
As we
have seen, and the Court of Appeals has noted, Dixon v.
Commissioner, 316 F.3d 1044 n.5, when Thompson was about to
reveal his settlement in open court, McWade immediately steered
him to another subject.
Nor did respondent's attorneys manifest
a consistent respect for the substance of the transaction.
In
substance, the Thompsons' settlement of their 1979-1981
deficiencies was a vehicle for payment of their attorney's fees,
but respondent, again through his former attorneys who
perpetrated the fraud, characterized it as a refund of taxes to
the Thompsons that·was solely attributable to Bauspar.
53 See Smith, "Substance over Form: A Taxpayer's Right to
Assert the Priority of Substance", 44 Tax Law. 137, 142 (1990).
- 95 .We therefore reject respondent's assertion of substance over
form.
We shall instead apply to respondent the nondisavowal
princíple of Commissioner v. Natl. Alfalfa Dehydrating & Milling
Co., supra at 149, that a party who has chosen to organize his
affairs in a certain fashion."must accept the tax consequences of
his choice, whether contemplated or not * * * and may not enjoy
the benefit of some other route he might have chosen to follow
but did not."
We believe the settlement of the Thompsons'
1979-
1981 deficiencies must be applied by giving effect to their
receipt of the entire amount of the refunds, rather than by
disregarding such receipt as a mere formality in the process of
what was, in substance, respondent's manipulation of the tax
-
administrative process to use the Thompsons as a conduit to pay
DeCastro's fees.
We are not cont.ent to rest our conclusion solely by invoking
the nondisavowal principle to hold respondent to the form of the
transaction.
To do so might give rise to. the implication that we
have disregarded the substance of the transaction.
If we did no
more than disregard the substance of the Thompson settlement by
upholding its form, respondent might well impeach our conclusion
by arguing that we thereby would have disregarded the mandate of
the Court of Appeals for the Ninth Circuit to put all petitioners
"in the same position as provided in the Thompson settlement".
- 96 We therefore push the analysis further by observing that our
conclusion accords. with principles of Federal income taxation
developed by the Supreme Court in analogous situations.
Specifically, our treatment of the Thompson settlement is
analogous to the treatment of taxpayers who are held to have·
received gross income, even though that income was paid directly
to a third party.
Petitioners cite Old Colony Trust Co. v.
Commissioner, 279 U.S. 716 (1929), in which the Supreme Court
held that an employer's payment of its employees' income taxes
should be recognized as a taxable payment of additional
compensation to the employee.5
Our conclusion is supported by the recent decision of the
Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005).
There, Mr. Banks settled an employment discrimination suit for
$464,000 and, pursuant to a contingent fee arrangement, paid his
attorneys $150,000 of that amount.
The Supreme Court held that
the $150,000 fee amount was includable in the gross income of. Mr.
Banks, notwithstanding his preexisting obligation to pay
.
54We note that the Thompsons did not report as gross income
the first refund of $30,000, presumably because it was a refund
of tax they had previously paid. Moreover, they did not claim
that amount as a deduction under sec. 212(3) when they endorsed
the check for that amount to DeCastro, as a partial payment on
account of his legal fees. Although their failure to claim the
deduction operated as a tax detriment to the Thompsons, there is
no evidence that their forbearance was in any way related to the
deal with McWade.
- 97 approximately one-third of his total recovery to his lawyers.
We read the Supreme Court's opinion in Banks as confirming and
applying the general principle that the portion of a settlement
that is dedicated to the payment of the plaintiff's attorney's
contingent fee is still regarded as received by the plaintiff
even though he is not expected or enti'tled to retain it.
Our conclusion is guided also by the fact that the Court of
Appeals has specifically directed us to provide the equivalent of
the Thompson settlement as a sanction against respondent.
We do
not believe that the Court of Appeals contemplated the
application of this aspect of the Thompson settlement in the way
that respondent urges, that is, as a 20-percent reduction in
proposed deficiencies, together with the hollow requirement that
respondent reimburse the many other affected petitioners for
attorney's fees that in fact they never incurred.
If we did so,
"We note that in Kenseth v. Commissioner, 114 T.C. 399
(2000), affd. 259 F.3d 881 (7th Cir. 2001), a majority of this
Court upheld respondent's contention that the taxpayers were
chargeable with the receipt of gross income on the portion of a
settlement that was used to pay their attorney under a contingent
fee arrangement.
In Kenseth, the taxable year was 1993, the
taxable year for which, in the matter at hand,·respondent
contends that we should disregard as a formality the Thompsons'
receipt of the second refund they used to pay their attorney.
We observe that our hewing to the form of the transaction as
generating refunds of tax and interest to the Thompsons obviates
any argument by petitioners that the Thompsons received a tax
benefit in not being required to report as gross income the
receipt of the refund of tax that enabled them to make their
first installment payment of DeCastro's attorney's fees.
- 98 we would not be applying the equivalent of the Thompsons' .1979-
1981 settlement; instead we would be applying essentially the
same 20-percent reduction settlement that McWade extended to
other taxpayers, .including other clients of Chicoine and Hallett
and DeCastro, the monetary benefit of which respondent would have
been content to allow the Thompsons to retain.
We believe the
modest deficiency reduction percentage urged by respondent would
not provide an appropriate sanction for misconduct that the'Court
of Appeals has held to be a fraud on this Court.
To adopt
respondent's view would be to ignore the financial terms and
effects of the final settlement that was sweetened for the
illicit purpose of creating the fund from which DeCastro's trial
fees could be paid.
We conclude that the Court of Appeals intended that the
Thompsons'
"secret agreement" with respect to 1979-1981, to the
extent it reflected the reduction of deficiencies to $30,000 for
those years, is to be applied as a reduction of 62.17 percent in
the Kersting deficiencies of the affected taxpayers, rather than
the 20-percent reduction urged by respondent, or some
intermediate percentage based upon the actual or expected amounts
of the refunds to be retained by the Thompsons after payment of
DeCastro's fees.
See supra note 51.
In terms of the "settlement
fraction" discussed above, we begin with a numerator of $30,000
(the total 1979-1981 tax deficiency the Thompsons paid) and a
- 99 denominator of $79,294 (the 1979-1981 tax deficiencies the
Thompsons would have paid absent the settlement).
D.
Other Benefits Relating to the Thompsons'
1981 Tax Year
1.
Elimination of the Thompsons' Late
Filing (Non-Kersting) Addition for 1981
Petitioners maintain that the denominator of the settlement
fraction should be increased by $4,934.32, representing the late
filing addition in the Thompsons' statutory notice for 1981 that
they would have had to pay absent the settlement of their 19791981 tax years.
We disagree.
Respondent's proposed application
of non-Kersting penalties and additions was specific to
individual taxpayers, unlike the Kersting-related deficiencies
and additions for which all affected taxpayers are liable.
For
that reason, we believe it is appropriate to limit the benefit of
this aspect of the Thompson settlement (relief from liability for
non-Kersting additions) to those affected taxpayers who,
042
Thompsons, were subject to non-Kersting additions.
like the
We therefore
deal with this aspect of the Thompson settlement separately from
our determination of the percentage reduction in Kersting
deficiencies that will apply to all affected taxpayers.
infra Part II.G.1.
See
- 100 2.
Respondent's Failure To Address the
Bauspar Issue in the Thompsons' Statutory
Notice for 1981
As discussed above, the Thompsons began participating in the
Bauspar program in 1981.
Respondent's notice of deficiency with
respect to the Thompsons' 1981 tax year did not disallow the
$8,000 claimed by the Thompsons on their 1981 return as home
mortgage interest, interest that was probably attributable to the
Bauspar program.
By August 1985, when the Thompsons filed their
petition in this Court for 1981, respondent was generally
precluded from revising the statutory notice to include the
Bauspar issue.
See sec. 6212(c)(1).
Because that cutoff date
predates the Thompsons' retention of DeCastro by more than a
year, respondent's failure to include the Bauspar issue in the
statutory notice for 1981 could not have been part of the secret
settlement agreement between DeCastro and McWade."
E.
Benefits to the Thompsons Relating to Years
Other Than 1979-1981
1.
In General
Respondent maintains that the only years covered by the
Thompson settlement were the Thompsons' 1979-1981.taxable years
before the Court in this proceeding.
Petitioners, on the other
"Respondent presumably could have raised the Bauspar issue
later by seeking leave·to amend his answer in the Thompsons' 1981
Tax Court case.
See sec. 6214(a); Rule 41(a); Rule 142(a)
(shifting the burden of proof to the Commissioner with respect to
the increased deficiency). For reasons discussed infra in Part
II.E.4., we need not concern ourselves with that possibility.
- 101 hand, maintain that the Thompson settlement covered a number of
years between 1979 and.1993, thereby increasing the percentage
reduction in Kersting deficiencies to which they are entitled to
79.95 percent."
They base this percentage on their calculation
that, absent the settlement, the amount of taxes the Thompsons
would have paid respondent for the taxable years 1979-1983, 198687, and 1993 was $143,894.10, while the amount they actually paid
042
was $28,894.87
($30,000 reduced by .$1,105.13 that respondent
maintains Mr. Thompson improperly received as reimbursement for
his travel to Hawaii to testify in the Dixon II trial).
We
examine various suspect benefits below.58
"In a separate brief, petitioners' counsel Sticht argues
for a "cashflow" approach to the calculation of the reduction
percentage, which would bring the initial reduction percentage to
86.8 percent of petitioners' aggregate deficiencies, additions.,
and interest. Without closely following the mechanics of
Sticht's calculation, we reject the cashflow approach out of
hand.
It completely disregards the time value of money
principles that underlie our Preliminary Comments.
See text
accompanying notes 38, 39, and 40, supra.
We also note that, in the course of the evidentiary.hearing
required by the Dixon V mandates, petitioners' counsel O'Donnell
and Jones filed motions for summary judgment of "100-percent
discount" as a sanction. We denied the motions and the motions
for reconsideration of our denials because of numerous
outstanding issues of material fact. With the completion of the
evi~dentiary hearing and issuance of our opinion herein, we now
regard petitioners' motions to characterize the Thompson
settlement as a 100-percent reduction in the Kersting-related
deficiencies as having been denied on the merits.
38We note that petitioners do not question the settlement of
the Thompsons' 1978 tax year, which was apparently the first year
for which the Thompsons claimed Kersting deductions.
In any
(continued...)
- 102 2.
The Thompsons' Escape From Kersting
Liability with Respect to 1982
As discussed earlier, the Thompsons claimed Kersting (and
probably Bauspar) deductions on their 1982 return sufficient to
reduce their adjusted gross income of $99,364 to $4,336.
Respondent took no action with respect to that return, and the
generally applicable 3-year period of limitations for the
Thompsons'
1982 tax year expired in May 1986.
Given the fact
that the Thompsons did not retain DeCastro until November 1986,
respondent's failure to act on the Thompsons' 1982 return before
the expiration of the 3-year period of limitations could not have
been part of the secret settlement agreement between DeCastro and
McWade.
Petitioners nevertheless maintain that the Thompsons' escape
from Kersting liability with respect to 1982 is attributable to
the DeCastro/McWade agreement.
point to DeCastro's August 3,
In support of that argument, they
1989 letter to McWade, which
states: "We have agreed that the total taxes due for all the open
years are $15,000 for 1980 and $15,000 for 1981." (Emphasis
added.)
Petitioners then argue that the Thompsons'
1982 tax year
was still fair game at that time because Mr. Thompson's fraud
rendered the statute of limitations inapplicable pursuant to
58(...continued)
..
event, that settlement was consummated in early to mid-1986,
before DeCastro came on the scene.
- 103 section 6501(c)(1).
They argue that Mr. Thompson was liable for
fraud because he had claimed.Kersting deductions even though he
believed he wouldn't have to pay the notes.
Petitioners' arguments are farfetched.
are serious business.
Allegations of fraud
The grounds for asserting civil fraud were
succinctly explained in Webb v. Commissioner, 394 F.2d 366, 377
(5th Cir. 1968). (quoting Carter v. Campbell, 264 F.2d 930,
042
935-936 (5th Cir. 1959)), affg. T.C. Memo. 1966-81:
"Fraud implies bad faith, intentional wrongdoing and a
sinister motive. It is never imputed or presumed and
the court should not sustain findings of fraud upon
circumstances which at most create only suspicion.
* * * Negligence, whether slight or great, is not
equivalent to the fraud with intent to evade tax
named in the statute.
The fraud meant is actual,
intentional wrongdoing, and the intent required is the
specific purpose to evade a tax believed to be owing.
Mere negligence does not establish either.
* * * "
We amplified these requirements in Fields v. Commissioner, T.C.
Memo. 2002-320:
To succeed in the instant case, respondent must
show that he had a reasonable basis for believing that
he could prove his allegation of petitioner's fraud by.
clear and convincing evidence.
See, e.g., Rutana v.
Commissioner, 88 T.C. 1329, 1337-1338 (1987). More
particularly, he must show that he had a reasonable
basis for believing that he could prove by clear and
convincing evidence that petitioner willfully intended
to evade a tax she believed to be owing.
In Fields, where we found that·respondent lacked a reasonable
basis for asserting fraud, we awarded attorney's fees to the
petitioner under section 7430.
T.C. Memo. 2004-272.
See also Benson v. Commissioner,
- 104 When DeCastro wrote to McWade confirming their deal,
respondent had not asserted fraud for any of the Thompsons'
taxable years that were before the Court, in all three of which
the Thompsons had claimed substantial Kersting-related
deductions.
Respondent, in fact, has not asserted fraud charges
against any of the test case or nontest case petitioners with
respect to Kersting deficiencies.
Nor, for that. matter, did
respondent even assert fraud charges against Kersting himself,
when respondent issued a deficiency notice to Kersting for his
failure to report more than $11 million of fee income he received
over a 7-year period (1982-88)
from the Kersting project
petitioners through his alter ego corporations.
See Kersting v.
Commissioner, T.C. Memo. 1999-197.
Nor do we believe the facts of the Thompsons' case would
support an assertion--much less a finding--of fraud against Mr.
Thompson.
Petitioners point to Mr. Thompson's trial testimony,
in which he "admitted that he had taken Kersting deductions while
believing the debt to which the deductions related would not have
to·be repaid."
We believe this testimony is true and consistent
with our findings in Dixon II and Dixon III regarding the
Kersting shelters.
We further believe this testimony falls far
short of demonstratiñg, by clear and convincing evidence, that,
by claiming the Kersting deductions, Mr. Thompson specifically
intended to evade a tax known to be owing.
Our skepticism is
- 105 based upon our perception that charging Mr. Thompson with fraud
in these circumstances would attribute to Mr. Thompson
substantially more knowledge of tax law than he ever had.
When
his 1982 tax return was filed, Mr. Thompson was a retired airline
pilot, who, like more than 1,000 of his colleagues duped by
Kersting, unwisely bought into a spurious tax shelter.
Petitioners apparently would have us accept the proposition that
042
Mr. Thompson was familiar with the laws governing the deduction
of interest payments where there is some question whether the
taxpayer involved is personally at risk.
This Court had substantial opportunity to evaluate the
credibility of Mr. Thompson, who testified for 2 days during the
evidentiary hearing mandated by DuFresne.
We found no basis for
suspecting him of fraud; to the contrary, if he had engaged in
fraud, we doubt he would have admitted that he didn't think he
was personally at risk on the Kersting notes.
Instead, we
concluded that his testimony at the tes.t case trial ''was
tEuthful."
More to the point, we believe Mr. Thompson's true beliefs
are those shown by his letter to McWade dated November 6,
1989.
In this letter, Mr. Thompson expressed his anger and confusion at
the part he had been made to play by the machinations of DeCastro
and McWade:
I received a check from IRS in thè amount of thirty
thousand dollars--($30,000).
I endorsed this over to
- 106 -
.
DeCastro Law Corp; this did not retire the billed
amount.
I am completely amazed at the billings we are
receiving.
I am now in receipt of additional billings
that exceed realistic amounts.
In fact the total comes
to sixty six thousand two hundred forty three and
66/100 dollars ($66,243.66). At some point I know a
reconciliation will come.
Luis [DeCastro] says don't
be concerned.. I am very concerned, I am the one being
billed.
*
*
*
*
*
*
*
Most emphatically I did not expect to be a channel
through which IRS funneled funds to any law firm.
Certainly not in this magnitude.
I have the feeling at
this point that I am correct in this--the bill is to
[sic] much.
I want to know the exact legal position I
occupy. We have been frustrated long enough. We wish
to close this chapter.
Mr. Thompson's reaction as displayed by this letter is not that
of a willing participant in a fraudulent conspiracy; instead,
it's the outrage of a mark who finally realizes he's been a tool
in somebody else's game.
The two cases cited by petitioners reinforce our conclusion.
In Popkin v. Commissioner, T.C. Memo. 1988-459, affd..without
published opinion 899 F.2d 21 (11th Cir. 1988), and Fried v.
Commissioner, T.C. Memo. 1989-430, affd. 954 F.2d 730 (11th Cir.f
1992), the Commissioner detërmined fraud penalties against tax
shelter promoters who themselves had invested in four types of
tax shelters, involving books, movies, lithographs, and coal
mining.
This Court rejected the Commissioner's fraud
determinations in the book, movie, and lithograph shelters.
Court did, however, sustain the fraud penalties against the
The
.
- 107 promoters for their participation in the coal-mining shelters.
These conclusions were based upon their complicity in backdating
documents and failing to deliver promissory notes.
Here, in
contrast, there is no evidence of Mr. Thompson's engaging in any
backdating, failure to make delivery, or any other dishonesty
"upon which, in large part" we relied in finding fraud in Popkin
and Fried.
In sum, there is not now, nor was there ever before, any
basis to assert fraud against Mr. Thompson for 1982.
Accordingly, the period of limitations for that year expired in
May 1986.
That being the case, the Thompsons'
not an open year to which DeCastro's August 3,
McWade could have applied.
1982 tax year was
1989,
letter to
We find.and hold that the Thompsons'
1982 taxable year was not affected by, and was not part of, the
Thompson settlement.59
59 In all likelihood, the Thompsons' 1982 tax year simply
slipped through the cracks as a result of the haphazard operation
of the audit lottery.
The record in these cases reveals numerous
other instances in which respondent failed to catch all the
taxable years of all the Kersting deductions claimed by
participants in Kersting's shelters. For example, test case
petitioners Richard and Fiorella Hongsermeier escaped audit for
their 1981 and 1982 taxable years, and respondent acknowledges
that the IRS "missed" the 1984 through 1986 taxable years of
other Kersting petitioners.
- 108 3.
The Thompsons' 1983 Kersting Deficiency
and the Disappearing Statutory Notice
Concerning the year 19.83, matters are substantially
different.
Unlike 1982, the Thompsons' 1983 tax return did not
slip through the cracks.
Instead, respondent's Fresno Service
Center had prepared a statutory notice of deficiency dated March
17, 1987, disallowing Kersting deductions and asserting a
deficiency of $980.
The statutory notice appears to have been
issued; notations in respondent's administrative records indicate
that.respondent received an inquiry regarding that notice in May
1987.
Nonetheless, no petition on behalf of the Thompsons was
filed in this Court regarding the deficiencies proposed for 1983.
Nor, moreover, did respondent assess or collect the deficiency
determined in the statutory notice.
Instead, for reasons not
explained, respondent's determination for 1983 was ignored, and
the year was allowed to lapse.
Early in 1987, when the Thompson statutory notice of
deficiency for 1983 was being prepared, McWade and DeCastro were
actively involved in resolving the Thompsons' tax matters
pursuant to their original settlement.
In March 1987, McWade
provided a sweetener of the original settlement that slightly
reduced the determined deficiencies for the years before the
Court to bring the reduction up to 20.55 percent.
Additionally,
during the prior December and January, he had helped process the
Thompsons'
interest payments for 1986.
- 109 If there were an explanation for the apparent abandonment of
assessment and collection procedures well under way for the
Thompsons' 1983 taxable year, we would expect respondent to be
able to provide one, but he has not.
Therefore, under the burden
of proof approach we have adopted, we hold that the Thompsons'
escape from a $980 deficiency for 1983 was part of the Thompson
settlement, and that this amount should be included in the
042
denominator for determining the percentage reduction in Kersting
deficiencies to be afforded all affected taxpayers before the
Court."
4.
The Thompsons'
Deductions
The Thompsons,
1983-85 Bauspar
like some other Kersting project
participants, apparently deducted substantial amounts as home
mortgage interest on their 1983-85 returns, on the basis of
payments under the Bauspar program that may not have met the
requirements for deductible home mortgage interest.
While
respondent concedes that the Thompsons probably derived a benefit
from overstated Bauspar interest deductions for those years, the
precise amount of that benefit is not readily ascertainable
"The last year for which the Thompsons claimed Kersting
deductions was 1984.
As discussed earlier, Revenue Agent Speers
ultimately disallowed the Thompsons' Kersting deductions for that
year ($7,740) in full, and the Thompsons paid the-resulting
deficiency of $1,830.
- 110 because the payees of claimed mortgage interest are not
identified on the returns.
Although the Thompsons were audited by the IRS for each of
the 1983-85 years, no deficiencies were ever determined against
them with respect to the Bauspar program, even though, as
respondent's counsel O'Neill reported:
"There are some other
docketed cases where we have disallowed mortgage interest."
We
believe that escaping Bauspar deficiencies was an implied term of
the Thompson settlement; while Sims and McWade knew that the
Thompsons had participated in the Bauspar program, the settlement
that they engineered assured that no Bauspar deficiencies were
determined, assessed, or collected from the Thompsons.
Thus, in
the absence of circumstances indicating that the Thompsons'
escape from Bau.spar-related deficiencies was not engineered by
Sims or McWade, we conclude that Bauspar relief was part of the
Thompson settlement."
Because the amounts of the Thompsons' Bauspar deductions are
incapable of determination with any precision, and because
respondent disallowed Bauspar deductions only sporadically for a
small number of taxpayers, we deal with this aspect of the
Thompson settlement separately from our determination of the
"In so holding, we do not retract our conclusion in Dixon
III that McWade and Sims lied in testifying that the final
Thompson settlement had the purpose and effect of giving the
Thompsons refunds by way of carrybacks of amounts they had lost
by reason of their participation in Bauspar.
- 111 percentage reduction in Kersting deficiencies that will apply to
all affected taxpayers.
5.
See infra Part II.G.2.
The Thompsons' Deduction of Prepaid
Interest on Their 1986 and.1987 Returns
1986
The Thompsons paid $25,545 of deficiency interest on
December 30, 1986.62
Because the Thompsons' adjusted gross
income for 1986 was relatively low, they ultimately were able to
use only $16,251 of deficiency interest as a deduction on their
1986 return.
Petitioners maintain that respondent should have
disallowed that deduction in its entirety because the Thompsons
did not pay the corresponding amount of the proposed deficiencies
in 1986.
Petitioners' argument requires us to examine the state of
the tax law as of December 30,
1986.
At that time, interest on
Federal income tax deficiencies was treated as "personal
interest", which was fully deductible by the taxpayer making the
payment.
See Robinson v. Commissioner, 119 T.C. 44, 54
(2002).
During 1986, however, the Internal Revenue Code was amended,
prospectively, to add a new section 163(h)., which repealed the
deduction for personal interest.
See TRA, Pub. L. 99-514, sec.
62Although the Thompsons purported to pay $59,545 of
deficiency interest on that date (and reported that amount as
deficiency interest expense on Schedule A, Itemized Deductions,
of their 1986 return), the larger of the two checks issued for
that purpose (in the amount of $34,000) was dishonored, and the
Thompsons did not send a replacement check until February 1987.
- 112 511(b), 100 Stat. 2246.
Under the provision, 1986 was the last
taxable year in which taxpayers could deduct 100 percent of such
personal interest.
TRA sec. 511(e), 100 Stat. 2246.
For the
next year, 1987, only 65 percent of personal interest was
deductible, and the deduction for personal interest was phased
out entirely by the end of 1989.
Sec. 163(h)(6).
In a news release issued October 23, 1986, the IRS advised:
"Since under the Tax Reform Act of 1986 interest on most tax
deficiencies of individual taxpayers will not be fully deductible
after 1986, taxpayers may wish to pay actual or contested
deficiencies now to obtain the full interest deduction on 1986
tax returns."
The news release accordingly included, as an
attachment, Announcement 86-108 (Ann. 86-108), 1986-45 I.R.B. 20,
which provided guidance to taxpay.ers wishing to obtain the full
deductibility of deficiency interest in 1986.
Under paragraph 4, "General Considerations", Ann. 86-108
states:
"In general, a taxpayer may not pay interest on a
contested deficiency without simultaneously paying, or agreeing
to pay, the underlying tax deficiency with respect to which the
interest is being paid."
The "Detailed Instructions" of Ann. 86-
108 describe two situations that arguably apply here.
Respondent
argues that the Thompsons' situation was governed by section
C.1.b.
("Taxpayers Desiring to Settle Their Tax Court Cases").
Under this provision a taxpayer whose case is pending before this
- 113 Court and who "wishes to settle the case on some.other basis than
a full concession" is directed to contact respondent's attorney
or Appeals officer to whom the case is assigned.
Then, "If a
settlement is agreed to, the attorney or Appeals Officer will
prepare the appropriate decision document."
Id.
In this case, when they prepaid their. interest, the
Thompsons (through DeCastro) had actually reached a settlement of
their liabilities for 1979-1981 with McWade.
McWade prepared the
appropriate decision documents, and he and DeCastro both signed
those documents, which reflected the settlement and contained an
express waivér of.the restrictions against assessment and
collection of the liabilities.
Accordingly, as of December 31,
1986, the Thompsons had agreed to pay approximately 80. percent of
the deficiencies originally determined against them, .and.their
attorney had, in fact, executed decision documents to that
effect.
Under section C.1.b of Ann. 86-108, the Thompsons'
agreement appears to have qualified their payment of deficiency
.interest for full deductibility.
Petitioners argue that another provision of Ann. 86-108
applies.
Section C.1.c. addresses "Taxpayers Desiring to Make a
Payment in 1986, While Continuing to Contest the Asserted
Deficiency in Tax Court".
That provision directs that, in order
to obtain an interest deduction for payment made in 1986 while
continuing to litigat.e before the Tax Court, the taxpayer must
- 114 simultaneously pay the amount of the contested tax deficiency to
which the interest being paid is attributable.
Petitioners note
that the agreement between DeCastro and McWade permitted the
Thompsons to receive the better of their settlement agreement or
the result of the Tax Court proceedings.
Accordingly,
petitioners argue, the Thompsons were, in effect, continuing to
contest the determined deficiencies in this Court within the
scope of Ann. 86-108, sec. C.1.c.
Petitioners therefore maintain
that because the Thompsons prepaid only the interest and none of
the contested tax deficiencies, the Thompsons were not entitled,
under Ann. 86-108 section C.1.c., to deduct the interest.
In Perkins v. Commissioner, 92 T.C. 749 (1989), a reviewed
opinion with no dissents, this Court held that a payment
designated as accrued interest made after a notice of deficiency
has been issued is deductible in the year paid, even though the
underlying tax has not been paid.
See also Preble v.
Commissioner, T.C. Memo. 1989-208.
We based our holding on two
provisions of the Internal Revenue Code:
Section 163(a), which
permits a deduction of·interest without requiring that the
underlying obligation be paid, and section 461(f), which permits
a deduction of interest in the year in which it is paid, even
though the taxpayer's liability for the underlying debt is
contested.
We concluded that the revenue procedure upon which
section C.1.c. of Ann. 86-108 is based had imposed "an
- 115 unwarranted restriction" by requiring payment of the obligation.
Perkins v. Commis.sioner, supra at 760.
Pet
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