A bankruptcy court held that a taxpayer was not liable for $40 million in penalties, assessed by the IRS for the taxpayer’s failure to register tax shelters he allegedly sold, because what the taxpayer sold was an “idea” and not a “tax shelter.” In re Canada, 2016 PTC 203 (Bankr. N.D. Tex. 2016).
William Canada graduated from Harvard law school in 1979 and worked at a variety of law firms, primarily as a commercial litigator. In 1994, Canada decided he was unhappy practicing law and should do something different. He left the firm he was working for and went to work for Heritage Organization, LLC.
At first, Canada was hired by Heritage as a “contractor,” and would meet with prospective clients in order to interest them in Heritage’s services, including the Heritage Transactions. Canada described the Heritage Transaction as a transaction in which a client would form an entity, an LLC, or some other type of pass-through entity like an S corporation, would open a brokerage account with a major brokerage firm, would sell Treasury securities short, and would then reinvest those into what were called “reverse repurchase agreements.” The brokerage account would then be contributed to a partnership, and at that point in time, the lawyers at Heritage would opine that the client created basis in the partnership equal to the amount of the proceeds of the Treasury short. The Heritage Transactions created a variety of opportunities to manufacture capital losses or to artificially offset capital gains.
By 1998, Canada was a key player at Heritage who was heavily involved in the marketing and sale of the Heritage Transactions to clients. Beyond his responsibility for marketing and selling the
Heritage Transactions, at some point Canada became Heritage’s President and/or Chief Operating Officer.
In 2007, the IRS began investigating Canada for possible liability for penalties for failing to register the Heritage Transactions he marketed between 1998 and 2001 as tax shelters under pre-2004 Code Sec. 6707 and pre-2004 Code Sec. 6111. Failure to register a “tax shelter” under pre-2004 Sec. 6111 led to penalties under pre-2004 Code Sec. 6707 equal to 1 percent of the aggregate amount invested in such tax shelter. However, it was not until April 2015 that the IRS told Canada of its intention to impose over $40 million in penalties against him pursuant to pre-2004 Code Sec. 6707 as a result of his actions as a Heritage employee. Canada then filed a voluntary petition for bankruptcy under Chapter 11 in September of 2015 in order to address the IRS’ penalty claim against him. The IRS filed an Original Proof of Claim on October 15, 2015, and Canada subsequently filed an objection to that claim.
Observation: Code Sec. 6111 and Code Sec. 6707 were revised from the ground up in 2004, after the relevant time period discussed above. Code Sec. 6111 now requires that any “material advisor with respect to any reportable transaction” file a return regarding that reportable transaction. Under the current version of Code Sec. 6111(c), the IRS determines via regulations whether something constitutes a reportable transaction. The legislative history of Code Sec. 6111 and Code Sec. 6707 does not shed much light on the reasons for the change to these provisions, but it seems clear that the potential realm of reporting requirements under the current version of Code Sec. 6111 sweeps far broader than it did under the prior version of the statute.
Under pre-2004 Code Sec. 6111(c), the definition of “tax shelter” begins with the phrase “[t]he term ‘tax shelter’ means any investment and goes on to characterize an “investment” as something
of which “interests” are “offered for sale.” Before a bankruptcy court, Canada argued that he was not liable for the $40 million in penalties because the Heritage Transactions were not “tax shelters” as that term was defined in pre-2004 Code Sec. 6111(c) because tax shelters under that provision had to be an “investment” and the Heritage Transactions were an idea or strategy
rather than an investment. Canada also argued that even if pre-2004 Code Sec. 6111 required him to register the Heritage Transactions as a tax shelter, he should not be liable for the penalties because he established reasonable cause for his failure to register them.
The bankruptcy court held that the Heritage Transactions were not investments as that term was used in pre-2004 Code Sec. 6111 and, thus, they could not be tax shelters. As a result, Canada was not liable for the $40 million in penalties assessed by the IRS. The court concluded that the plain meaning of the word “investment” did not encompass the Heritage Transactions. Black’s Law Dictionary, the court observed, defines “investment” as an expenditure to acquire property or assets to produce revenue, a capital outlay, or the asset acquired or the sum invested. The phrase “capital outlay” is then defined as “an outlay of funds to acquire or improve a fixed asset” or as “money expended in acquiring, equipping, and promoting a business.” The Heritage Transactions, the court observed, were not covered by any of these senses of the word “investment,” or by a common sense, everyday understanding of the word because the transactions were not (1) a revenue-producing asset such as real estate, (2) a share of a business entity, or (3) funds expended to acquire those kinds of assets or to fund a business.
The bankruptcy court also held that, in the event that an appellate court disagrees with its decision and concludes that the Heritage Transactions were “investments” and thus a “tax shelter” under pre-2004 Code Sec. 6111(c), Canada established reasonable cause under pre-2004 Code Sec. 6707 for his failure to register the Heritage Transactions as a tax shelter. The court stated it was satisfied that Canada’s own examination of his possible reporting obligations under pre-2004 Code Sec. 6111, combined with a lack of an obvious way to fit the Heritage Transactions into the statutory framework of pre-2004 Code Sec. 6111 and the dearth of authority interpreting that statute, was sufficient to establish his reasonable cause in not registering the transactions.