The KPMG Tax Shelter Prosecutions

The Indictment

The Indictment alleges that the conspiracy had four objects: 1) to defraud the IRS by impeding, impairing, defeating and obstructing the lawful governmental functions of the IRS in the ascertainment, evaluation, assessment and collection of income taxes, United States v. Klein, 247 F.2d 908, 915 (2d Cir. 1958); 2) to evade and defeat income taxes owed by the tax shelter clients and others, IRC ' 7201; 3) to make and subscribe or cause others to make and subscribe false federal individual, corporate and partnership tax returns, IRC ' 7206(1); and 4) to aid and assist in the preparation and presentation of false individual, corporate and partnership tax returns, IRC ' 7206(2). Indictment '' 44-48.

The Indictment focuses on four tax shelters marketed to individuals who had taxable income or gains exceeding $10 million. The clients allegedly were sold tax shelters that would generate losses to eliminate or reduce their taxes for an “all-in cost” of 5%-7% of the desired tax loss. The cost included the fees of KPMG (equal to approximately 1.25% of the desired tax loss), of certain purported investment advisers, of various law firms that supplied opinion letters, of the bank participants, as well as a small portion that was used to make the shelters look like investments. The size of the “investments,” the timing of the transactions, and the fees were all allegedly based on the tax loss to be generated.

The Indictment also contains a detailed narrative accusing a number of KPMG tax partners of: 1) preparing false and fraudulent tax returns for shelter clients; 2) drafting false documentation underlying the shelters; 3) issuing opinions that purported to rely upon the false documents, although the KPMG tax partners knew they were not true; 4) concealing the truth from the IRS by hiding losses and income on tax returns, failing to register the shelters, and asserting sham attorney-client privilege claims; 5) knowingly failing to locate and produce all documents called for by IRS summonses and misrepresenting to the IRS the nature and extent of KPMG's role with respect to certain tax shelters; and 6) obstructing an investigation of the tax shelter industry conducted by the U.S. Senate Permanent Subcommittee on Investigations in 2003.

Defense Strategy

The defense to these charges is likely to embrace the position that these “tax strategies” were a legitimate form of tax avoidance — an established feature of our fiscal system. As stated by Judge Learned Hand: “[A] transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes … Therefore, if what was done here, was what was intended by [the statute], it is of no consequence that it was all an elaborate scheme to get rid of income taxes, as it certainly was.” Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir.), aff'd, 293 U.S. 465 (1935) (citations omitted). Nevertheless, saying that a taxpayer has a right to arrange his affairs to reduce his taxes and pay only what is due under the law “tells us nothing about what must ultimately be rendered unto the IRS any more than Socrates solved the thorny problems of justice by defining it to require that we give every person his due.” United States v. Ingredient Technology Corp., 698 F.2d 88, 94 (2nd Cir. 1983).

In theory, the distinction between avoidance and evasion is reasonably clear: One who evades taxes believes he has underreported his tax liability, while one who avoids believes that he has reported it properly. A plan to reduce taxes becomes a scheme to evade taxes if it involves conduct that is knowingly and intentionally calculated to prevent disclosure of the truth. In Ingredient Technology, the corporate taxpayer, a sugar refiner, boosted its LIFO inventory by purchasing sugar at year-end under an oral agreement to sell it back at the beginning of the next fiscal year. The Second Circuit held that the LIFO inventory had been overstated because the transaction produced no beneficial interest to the corporation except to inflate inventory for a few days solely for tax purposes. Because corporate officers lied to outside auditors and attorneys about the resale agreement and a secret letter about it that was hidden in a safe and later destroyed, the court held there was sufficient proof of willful intent to commit tax fraud.

A Brief History

Criminal investigation and prosecution of abusive tax shelters date back to 1977, when the Criminal Investigation Division of the IRS instituted an Abusive Tax Shelter Project. Prosecutions frequently proved that the transactions at issue had no economic substance or business purpose, and that the sole object was the creation of tax losses for wealthy investors who paid large fees to promoters of the shelters. Because the formalities of the transactions were observed, the defendants argued that these were not sham transactions that could be the basis for criminal charges. Courts rejected this defense because sham transactions include not only fictitious transactions, but also transactions that have “no business purpose or economic effect other than the creation of tax deductions.” United States v. Atkins, 869 F.2d 135, 139-140 (2d Cir. 1989).

In Atkins, the tax shelters involved rigged straddles and rigged repurchase agreements of U.S. government securities. In affirming the conviction of the promoters under 18 U.S.C. ' 371 and IRC ' 7206(1) and (2), the Court of Appeals rejected the argument that the defendants did not know in advance that their conduct was unlawful, pointing to the evidence in the record of back-dated documents, disguising kickback payments as trading losses, and lying to the defendant's lawyers, accountants and customers concerning the true nature of their machinations.

At the arraignment of the nine defendants in the KPMG Indictment on Sept. 6, 2005, the prosecutors announced that they plan to obtain a superseding indictment adding further criminal charges against these defendants and adding new defendants. It remains to be seen whether the proof at trial will establish beyond a reasonable doubt that the conduct of the defendants crossed the often elusive line between aggressive tax planning and criminal tax fraud.

On Aug. 29, 2005, the Department of Justice, the IRS and KPMG LLP (KPMG) announced that an agreement had been reached with the U.S. Attorney's Office for the Southern District of New York resolving the Grand Jury investigation into tax shelters designed, developed and sold by KPMG from 1996 to 2002 and related conduct. The settlement also resolved the IRS's examination of these activities. KPMG and the government entered into a deferred prosecution agreement (DPA), pursuant to which KPMG acknowledged responsibility for engaging in a massive tax fraud conspiracy that generated at least $11 billion in fraudulent tax losses, which cost the government at least $2.5 billion in evaded taxes.

The DPA requires KPMG to pay a criminal fine of $128 million, restitution to the IRS of $228 million, and an IRS penalty of $100 million — a total of $456 million, to be paid by Dec. 21, 2006. These payments will not be tax deductible nor covered by insurance. The criminal charge will be dismissed on Dec. 31, 2006, if KPMG complies with the stringent terms and conditions of the DPA. These include:

• Restrictions and elevated standards for tax practice;
• Full cooperation with the government's ongoing investigation;
• The tolling of the statute of limitations;
• Maintaining a compliance and ethics program that meets the criteria of the Sentencing Guidelines;
• An independent monitor to check compliance with the DPA; and
• An IRS closing agreement that provides for enhanced oversight of KPMG's tax practice.

KPMG's global settlement enables it to avoid a criminal conviction that would probably have put it out of business like its former competitor Arthur Andersen LLP.

Prosecution of individuals, however, was not deferred. The government unsealed a single-count, 44-page indictment of eight former KPMG partners, one manager, and a former tax partner in the New York office of a prominent national law firm. They are accused, along with alleged co-conspirators, of participating in “a scheme to defraud the IRS by devising, marketing, and implementing fraudulent tax shelters, by preparing and causing to be prepared, and filing and causing to be filed with the IRS false and fraudulent U.S. individual income tax returns containing the fraudulent tax shelter losses, and by fraudulently concealing from the IRS those shelters.” United States v. Jeffrey Stein, et al., 05 Crim. 888 (S.D.N.Y. August 29, 2005), Indictment ' 15.

The Indictment

The Indictment alleges that the conspiracy had four objects: 1) to defraud the IRS by impeding, impairing, defeating and obstructing the lawful governmental functions of the IRS in the ascertainment, evaluation, assessment and collection of income taxes, United States v. Klein , 247 F.2d 908, 915 (2d Cir. 1958); 2) to evade and defeat income taxes owed by the tax shelter clients and others, IRC ' 7201; 3) to make and subscribe or cause others to make and subscribe false federal individual, corporate and partnership tax returns, IRC ' 7206(1); and 4) to aid and assist in the preparation and presentation of false individual, corporate and partnership tax returns, IRC ' 7206(2). Indictment '' 44-48.

The Indictment focuses on four tax shelters marketed to individuals who had taxable income or gains exceeding $10 million. The clients allegedly were sold tax shelters that would generate losses to eliminate or reduce their taxes for an “all-in cost” of 5%-7% of the desired tax loss. The cost included the fees of KPMG (equal to approximately 1.25% of the desired tax loss), of certain purported investment advisers, of various law firms that supplied opinion letters, of the bank participants, as well as a small portion that was used to make the shelters look like investments. The size of the “investments,” the timing of the transactions, and the fees were all allegedly based on the tax loss to be generated.

The Indictment also contains a detailed narrative accusing a number of KPMG tax partners of: 1) preparing false and fraudulent tax returns for shelter clients; 2) drafting false documentation underlying the shelters; 3) issuing opinions that purported to rely upon the false documents, although the KPMG tax partners knew they were not true; 4) concealing the truth from the IRS by hiding losses and income on tax returns, failing to register the shelters, and asserting sham attorney-client privilege claims; 5) knowingly failing to locate and produce all documents called for by IRS summonses and misrepresenting to the IRS the nature and extent of KPMG's role with respect to certain tax shelters; and 6) obstructing an investigation of the tax shelter industry conducted by the U.S. Senate Permanent Subcommittee on Investigations in 2003.

Defense Strategy

The defense to these charges is likely to embrace the position that these “tax strategies” were a legitimate form of tax avoidance — an established feature of our fiscal system. As stated by Judge Learned Hand: “[A] transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes … Therefore, if what was done here, was what was intended by [the statute], it is of no consequence that it was all an elaborate scheme to get rid of income taxes, as it certainly was.” Helvering v. Gregory , 69 F.2d 809, 810 (2nd Cir.), aff'd, 293 U.S. 465 (1935) (citations omitted). Nevertheless, saying that a taxpayer has a right to arrange his affairs to reduce his taxes and pay only what is due under the law “tells us nothing about what must ultimately be rendered unto the IRS any more than Socrates solved the thorny problems of justice by defining it to require that we give every person his due.” United States v. Ingredient Technology Corp. , 698 F.2d 88, 94 (2nd Cir. 1983).

In theory, the distinction between avoidance and evasion is reasonably clear: One who evades taxes believes he has underreported his tax liability, while one who avoids believes that he has reported it properly. A plan to reduce taxes becomes a scheme to evade taxes if it involves conduct that is knowingly and intentionally calculated to prevent disclosure of the truth. In Ingredient Technology, the corporate taxpayer, a sugar refiner, boosted its LIFO inventory by purchasing sugar at year-end under an oral agreement to sell it back at the beginning of the next fiscal year. The Second Circuit held that the LIFO inventory had been overstated because the transaction produced no beneficial interest to the corporation except to inflate inventory for a few days solely for tax purposes. Because corporate officers lied to outside auditors and attorneys about the resale agreement and a secret letter about it that was hidden in a safe and later destroyed, the court held there was sufficient proof of willful intent to commit tax fraud.

A Brief History

Criminal investigation and prosecution of abusive tax shelters date back to 1977, when the Criminal Investigation Division of the IRS instituted an Abusive Tax Shelter Project. Prosecutions frequently proved that the transactions at issue had no economic substance or business purpose, and that the sole object was the creation of tax losses for wealthy investors who paid large fees to promoters of the shelters. Because the formalities of the transactions were observed, the defendants argued that these were not sham transactions that could be the basis for criminal charges. Courts rejected this defense because sham transactions include not only fictitious transactions, but also transactions that have “no business purpose or economic effect other than the creation of tax deductions.” United States v. Atkins , 869 F.2d 135, 139-140 (2d Cir. 1989).

In Atkins, the tax shelters involved rigged straddles and rigged repurchase agreements of U.S. government securities. In affirming the conviction of the promoters under 18 U.S.C. ' 371 and IRC ' 7206(1) and (2), the Court of Appeals rejected the argument that the defendants did not know in advance that their conduct was unlawful, pointing to the evidence in the record of back-dated documents, disguising kickback payments as trading losses, and lying to the defendant's lawyers, accountants and customers concerning the true nature of their machinations.

At the arraignment of the nine defendants in the KPMG Indictment on Sept. 6, 2005, the prosecutors announced that they plan to obtain a superseding indictment adding further criminal charges against these defendants and adding new defendants. It remains to be seen whether the proof at trial will establish beyond a reasonable doubt that the conduct of the defendants crossed the often elusive line between aggressive tax planning and criminal tax fraud.