On February 24, 2017, the United States District Court for Wyoming, in McNeill v. United States, held that a taxpayer who had invested in a distressed asset/debt tax shelter transaction did so based on a good-faith reliance on his advisors and was not liable for accuracy-related penalties assessed by the IRS. Although the taxpayer was a former navy commander and chief executive of a major corporation, the district court found that he was not knowledgeable or sophisticated about the distressed asset/debt transaction, and he relied on the advice of competent tax advisors who were experts in the design and implementation of the transaction. Following a bench trial, the court found the testimony of the taxpayer to be credible, and concluded that the taxpayer sought and obtained a positive, independent opinion from his tax advisor, E&Y, and from qualified lawyers that the strategy was compliant and lawful under the partnership provisions of the Code. Lawrence Hill, a tax partner at Winston & Strawn LLP, told Bloomberg BNA, that “this is one of the more favorable reasonable cause cases in the tax shelter arena that have come down. The court acknowledged that the decision was a “close call,” but must have believed that the taxpayer was a very credible witness because other courts have rejected the defense in analogous circumstances.”
In 2002, the McNeills invested in a distressed asset/debt (“DAD”) transaction in the form of a Brazilian account receivable. The DAD transaction was promoted to McNeill as a legitimate transaction by others whom McNeill trusted or came to trust. The government audited the McNeills’ 2002 joint tax return and concluded that the DAD transaction was an illegal tax avoidance transaction, resulting in a phony $20 million loss. As a result, the IRS assessed the McNeills approximately $7.75 million, representing tax, interest, and accuracy-related penalties, which the McNeills paid in full. Thereafter, the McNeills made a refund claim of the penalty and interest amount. The McNeills argued that they had “reasonable cause” for the position they took and they filed their joint tax return in “good faith.” The IRS did not respond to their refund claim, so the McNeills filed a petition for refund of penalties with the federal district court in Wyoming.
McNeill, a former Commander of a nuclear submarine in the United States Navy, was the chairman of the board and CEO of Exelon, until he retired in 2002. Under the terms of McNeill’s separation agreement with Exelon, he realized approximately $66 million in gross income. In 2002, McNeill, who was interested in investment opportunities with positive tax benefits, discussed investment options with his advisors at E&Y. During his discussion with E&Y, McNeill, through the recommendation of a colleague, began inquiring into distressed debt opportunities, which led him to the BDO accounting firm. At a meeting in November 2002, BDO explained the structure of the DAD transaction and how it could be used to generate a large loss with little economic outlay. BDO explained that if debt is “distressed debt” (i.e., debt with low collection potential), like the Brazilian accounts receivable, it will have a high face value, but a low fair market value. BDO suggested to McNeill that he enter into a DAD transaction – the idea was to use a series of partnerships and sets of transactions to eventually transfer to the McNeills losses that foreign debt holders had already suffered by the way of the distressed debt, so that the McNeills could claim their losses and deductions against the high severance package income expected in 2002.
Analysis of Reasonable Cause Defense
The district court’s analysis began with a review of Section 6664(c)(1), which provides that the accuracy-related penalty shall not be imposed if the taxpayer establishes there was reasonable cause for the tax position that resulted in the penalty and the taxpayer acted in good faith in taking that position. The taxpayer has the burden to prove that the Commissioner’s accuracy-related penalty determinations under Section 6662 are incorrect, and bears the burden of proof on its reasonable cause and good faith defense. The district court, after a review of the facts, concluded that the McNeills had satisfied their burden and granted the taxpayers’ petition for refund of the penalties and interest. The court found McNeill’s testimony credible and made the following findings of fact:
- Prior into entering into the DAD transaction, E&Y looked into the DAD transaction strategy at McNeill’s request, obtained information about it from BDO, and reviewed a variety of documents to implement the strategy. In addition, E&Y prepared tax projections, which anticipated a $20 million loss. E&Y managed the basis-build required for the anticipated 2002 loss. Moreover, McNeill testified that he expected E&Y to ask questions necessary to form its opinion about whether the strategy worked under the tax laws.
- McNeill obtained a favorable legal opinion written by the De Castro, West law firm, which blessed the tax aspects of the DAD transaction.
- Before signing their 2002 joint tax return, no one told McNeill that taking the $20 million loss on his 2002 tax return would be illegal or against the tax code.
- None of McNeill’s advisors mentioned the sham transaction doctrine, the economic substance doctrine, or the step transaction doctrine, or any other anti-abuse doctrines or provisions.
- There was no evidence in the record to suggest anyone from E&Y advised McNeill that the partnerships could be disregarded under any of the anti-abuse doctrines or provisions discussed in the De Castro opinion.
- The De Castro opinion concluded that the DAD transaction (and partnerships) would survive the application of any anti-abuse doctrine.
- No advisor alerted McNeill about the importance of a profit motive, business purpose, and economic substance underlying the partnerships and DAD transaction.
- McNeill was sophisticated in business. However, he did not appear to have understood the transaction’s design and implementation to exploit the tax code’s partnership provisions.
- The fact that McNeill signed a representation letter drafted by De Castro, which contained representations or assumptions that were not true, did not destroy McNeill’s reasonable cause and good faith.
In addition, the IRS argued that the McNeills cannot rely on E&Y’s advice because E&Y’s engagement letter specifically states E&Y is not providing tax or legal advice, and all advice must be in writing. The district court was not persuaded by the IRS’s argument, and found that the “engagement letter is limited on its face to investment advisory services, which is a very small percentage of the work done for Mr. McNeill by E&Y, and does not preclude the reasonableness of his reliance on oral advice indisputably given in the case.”