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Tax Fraud Busted – Cost $1 Billion!!

Texas Tycoon Liable for Over $1 Billion to IRS for Using Offshore Entities to Avoid Taxes

A Texas bankruptcy court found a former billionaire liable for back taxes, interest, and penalties totaling more than $1 billion. While the court held that the billionaire and his late brother were guilty of tax fraud as a result of their use of offshore trusts and corporations to avoid the payment of income taxes, the court found the late brother’s widow was eligible for innocent spouse relief. In re Wyly, 2016 PTC 233 (Bankr. N.D. Tex. 2016).

Background

In 2010, the Securities and Exchange Commission (SEC) sued Sam Wyly and his brother, Charles Wyly, and others, for securities fraud in connection with certain transactions undertaken by various offshore trusts and offshore corporations that the brothers were involved with setting up. The case was tried in a New York district court. The fraud was alleged to have been accomplished through an elaborate sham system of trusts and subsidiary companies located in the Isle of Man and the Cayman Islands (the “Offshore System”). The Offshore System enabled the Wylys to hide their ownership and control of certain securities through trust agreements that purported to vest complete discretion and control in the offshore trustees. In actual fact and
practice, the court found, the Wylys never relinquished their control over the securities and continued throughout the relevant time period to vote and trade these securities at their sole discretion. Through their use of the Offshore System, the Wylys were able to sell, without disclosing their beneficial ownership, over $750 million worth of securities, and to commit an insider trading violations resulting in unlawful gain of over $31.7 million.

The brothers were found guilty and a judgment was entered against Sam and the probate estate of Charles, who died in 2011, for approximately $124 million and $64 million, respectively, plus prejudgment interest. In 2014, following the verdict, Sam and Caroline Wyly, Charles’ widow, filed for bankruptcy. The IRS assessed multiple fraud penalties against the Wylys relating to tax underpayments as a result of the Offshore System, including underpayments of gift tax relating to transfers of property to family members. A trial before a Texas bankruptcy court ensued. Because of the determinations by the district court in the SEC trial, and because the bankruptcy court gave collateral estoppel effect to the district court’s determinations, the parties
agreed that there were substantial underpayments of income taxes by the Wylys as a result of the Offshore System. The Wylys asked the bankruptcy court to determine the amount of allowed IRS claims against them.

In defense of its charges against the Wylys, the IRS claimed that Sam and Charles, along with their army of lawyers and other professionals, set up one of the most complicated offshore structures ever seen, and then manipulated that structure in such a way as to evade their legitimate tax obligations.

The Wylys first argued that the IRS failed to prove fraudulent intent because the Wylys relied on the advice of various professionals in preparing and filing their tax returns in each of the relevant years and that negated any possible fraudulent intent. Alternatively, the Wylys asserted reasonable cause and good faith defenses to the imposition of fraud penalties for their income tax underpayments.

In addition, Caroline claimed that she was eligible for innocent spouse relief under Code Sec. 6015(b) and Code Sec. 6015(c).

Analysis

The bankruptcy court upheld the majority of the IRS’s penalty assessments against Sam, resulting in a liability of more than $1 billion in back taxes, interest, and penalties. The court found him liable for $427 million in penalties alone for failing to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, and Form 5471, Information return of U.S. Persons with Respect to Certain Foreign Corporations. The court rejected the argument that the
penalty, which was more than three times Sam’s tax liability, was excessive. The court also found Charles guilty of fraud, leaving his estate subject to assessments for back taxes, interest, and penalties.

The court noted that Sam is a sophisticated and well-educated businessman that accumulated great wealth through his business acumen and hard work. And, while he may have left the day-to-day business details to professional managers and advisors he hires, it was clear to the court that he expected results and was knowledgeable about the results various professionals obtained on his behalf. He did not, the court said, simply turn his wealth over to others and wish them luck. The bankruptcy court was convinced Sam knew what was happening in connection with the offshore system and that no money or assets moved within that system without Sam’s knowledge and express direction. While Sam’s directions to the offshore trustees was usually done through the formality of Sam making his “wishes” known to them, the court observed, the trustees never refused to follow Sam’s “wishes” as they understood that their jobs depended upon it. If a Sam “wish” was not granted, the court noted, the trustees would be removed. Sam, the court continued, could not expect to hide behind others and claim not to have known what was going on around him. The documents introduced into evidence, including those that were created to attempt to shield Sam, pointed to fraud, the court said.

However, the court did not find that Sam owe gift taxes relating to transfers of property to family members. The court rejected the IRS’s theory that Sam made a gift of cash to his children by way of the property transfers. According to the court, since the properties at issue were purchased using mostly offshore funds, Sam never gave up control over those properties after their purchase. The court noted that while one of Sam’s daughters was allowed to exercise control over those properties day-to-day, Sam had the ability to remove her at any time. Moreover, the court said, the fact that Sam’s children could use the properties did not make them, or the cash used to purchase, improve, and maintain them, a gift. And the court observed, one of the offshore trusts still owned the properties at issue, albeit indirectly.

Finally, the bankruptcy court held that Caroline was innocent of any wrongdoing. The court found that she did not know the details of what Sam and her husband, Charles, had done offshore. And, the court said, there was nothing that should have “tipped her off” that something was amiss. She did not commit fraud, she did not participate in any fraud, she was not willfully blind, and the court concluded she was thus entitled to innocent spouse relief.

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