The Ninth Circuit today affirmed, in Swartz v KPMG et al (9th Cir., Feb 12, 2007), most of the decisions of the district court in the suit by Theodore Swartz against KPMG, Brown & Wood, Deutsche Bank, and Presidio Securities related to a "BLIPS" transaction promoted by the defendants and taken part in by the plaintiff in the case. Specifically, the Ninth Circuit affirmed the district court's dismissal with prejudice of the plaintiff's RICO and Washington Consumer Protection Act claims, as well as plaintiff's claim for declaratory judgment that the defendants would be liable for penalties and interest should they arise under an IRS audit. But the Ninth Circuit reinstated the plaintiff's claim for common-law fraud, permitting additional claims, further jurisdictional support, and a decision at trial on the issue of reasonable reliance.
The case involves Swartz's sale of his business in 1999 for an $18 million gain and the various defendants' involvement in promoting a tax shelter strategy called "bond linked issue premium structure" to create artificial losses that Swartz could use to offset the gain, with opinion letters from KPMG and Brown & Wood that would allegedly protect Swartz from any penalties. The transaction is described by the court as follows.
KPMG and Presidio facilitated the extension of a multi-million dollar line of credit from [Deutsche Bank] to Swartz. Swartz created a new limited liability company, Longs Strategic Investment Fund (“Longs”), and engaged Presidio as its manager. The credit facility was contributed to Longs. Longs held various assets including a number of shares of Microsoft common stock. After engaging in two foreign currency transactions intended to give Longs the appearance of a legitimate business, Presidio directed that Longs be dissolved. On December 13, 1999, the company was dissolved and the Microsoft stock was transferred to Swartz as part of his ownership assets. The intended effect of these transactions was to artificially inflate Swartz’s basis in the Microsoft stock so that he could sell it and claim a capital “loss” in the amount of the difference between his inflated basis and the value of the stock [, a loss of approximately $18 million].
An IRS 1999 notice and Notice 2000-44 indicate the IRS position that losses generated in BLIPS-type transactions should not be respected. Nonetheless, Swartz claimed the BLIPS losses on his 1999 return, and the case does not indicated whether he disclosed the transactions in response to the IRS amnesty provisions for settlement of contested claims to such losses. Back in 2003, when the suit was commenced, KPMG claimed that its tax advice was sound and that the suit was "without merit." See George Erb, Tax Advisers Sued, Puget Sound Business Journal (June 20, 2003). Of course, after the Senate investigative subcommittee's report (Appendix A covers the KPMG BLIPS transaction, indicating that KPMG sold the deal to 186 individuals, making $53 million), and in connection with settlement of the criminal case against KPMG (and continued litigation involving KPMG principals at the time), KPMG has admitted that its tax advice in these and other deals was inappropriate. And recently, a district court in Texas ruled that the BLIPS shelter was not a legitimate application of the tax rules. See Lynnley Browning, Court Rejects Tax Shelter, New York Times (Feb. 2, 2007).
The Ninth Circuit allowed the common-law fraud claim to proceed since it considered it possible that the plaintiff could establish that he relied on the defendants' oral assurances about the ability to use the tax losses, even though the KPMG engagement letter provided plaintiff in connection with the transaction clearly indicated that the transaction was "aggressive" and might be disallowed on audit. The Court notes that KPMG's assurance that the scheme was "more likely than not" to be sustained could be viewed as deceptive, given the claim by plaintiff that defendants knew that it would not succeed at audit.
The gravamen of Swartz’s complaint is that the defendants represented BLIPS as an effective taxavoidance strategy and collected substantial fees to implement the scheme despite knowing that it had no chance of success. While the engagement letter acknowledges the possibility of an audit, it also contains assurances that the plan would more likely than not be upheld over an IRS challenge.
Furthermore, the Court noted that the other facts that argue against reasonable reliance are not sufficient in and of themselves to dismiss the claim at this stage in the proceeding.
[The District Court] highlighted (1) that [plaintiff's later tax attorney] Moss Adams warned of the likely failure of the BLIPS claim and resigned from preparing Swartz’s taxes in October 2000, (2) that KPMG advised that the tax advantages might be disallowed by the IRS around the same time, and (3) that Swartz nevertheless filed his 1999 tax return claiming BLIPS losses and failed to amend it through 2002.
This case serves to remind us that a taxpayer who disregards hints about the overly aggressive nature of a tax scheme suggested by a promoter may not be an innocent bystander in the use of the aggressive scheme. Maybe Swartz should be pitied for being the object of the promoters' pressure to use the "too good to be true" device of the BLIPS transaction structure to avoid tax on the $18 million in unrelated capital gains from the sale of his business. For my part, I find the facts pointed out by the district court a strong case that the taxpayer was unreasonable to rely on the promoters' sales pitches (though, as the Ninth Circuit says, perhaps not sufficient for a decision as a matter of law).
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