U.S. v. Mallas

• Decision Date: 20 May 1985
• Docket Number: Nos. 84-5085,s. 84-5085
• Citation: 762 F.2d 361
• Parties: -5045, 85-1 USTC P 9408 UNITED STATES of America, Appellee, v. James G. MALLAS; Robert V. Jones, Jr., Appellants. (Two Cases) (L), 84-5258.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 361

762 F.2d 361

56 A.F.T.R.2d 85-5045, 85-1 USTC P 9408

UNITED STATES of America, Appellee, v. James G. MALLAS; Robert V. Jones, Jr., Appellants. (Two Cases)

Nos. 84-5085(L), 84-5258.

United States Court of Appeals, Fourth Circuit.

Argued Feb. 6, 1985.

Decided May 20, 1985.

R. Stan Mortenson, Washington, D.C. (Jonathan B. Sallet, Miller, Cassidy, Larroca & Lewin, Washington, D.C., on brief), for appellants.

Deborah Wright Dawson, Dept. of Justice, Tax Division, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Washington, D.C., Charles R. Brewer, U.S. Atty., Asheville, N.C., Michael L. Paup, Robert E. Lindsay, Dept. of Justice, Tax Division, Washington, D.C., on brief), for appellee.

Before SPROUSE and WILKINSON, Circuit Judges, and HAYNSWORTH, Senior Circuit Judge.

WILKINSON, Circuit Judge:

Defendants appeal from their convictions for evasion of federal income taxes. We find that their contested business practices raise novel questions of tax liability to which governing law offers no clear guidance. Because the defendants therefore could not have ascertained the legal standards applicable to their conduct, criminal proceedings may not be used to define and punish an alleged failure to conform to those standards. We reverse the convictions.

I

James G. Mallas and Robert V. Jones, Jr., investment counselors in Charlotte North Carolina, began in 1977 to design a tax shelter program based on deductions allowed to participants in coal-mining enterprises. Mallas, as sole shareholder, formed Genesis Leases, Inc., for the corporate purpose of locating and purchasing leases of coal property in Kentucky. Jones, as sole shareholder, formed Trinity Properties, Inc., which would sublease the coal rights from Genesis for $3.40 per extracted ton. Trinity would then re-sublease its rights to individual investors for $3.50 per extracted ton. These investors would contract to pay Trinity an advance minimum royalty during each year for the four-year lease period. In return, Trinity warranted that economically recoverable coal in the leased property was sufficient to permit the investor to recoup his advance minimum royalties; if the coal reserves proved to be inadequate, Trinity promised to supplement the lease with other property that would allow for complete recoupment. Finally, Mallas, as sole shareholder, formed Omega Energy, Inc., to purchase from the individual investors, for specified royalties, their rights to mine coal. Omega would then mine and market the coal, either by itself or by subcontract.

Omega Energy also served an important purpose in the financial structure of Mallas and Jones's tax shelter program. The investor, who was obligated to pay Trinity an individually negotiated advance minimum royalty, had to pay at least 2/7 of that amount from personal funds. The investor could then, if he wished, borrow the remaining 5/7 from Omega in exchange for a non-recourse promissory note secured by the investor's subleased mineral rights. As Omega mined and sold each ton of coal, it would retire the non-recourse note by retaining half of the royalty that it owed the investor. Omega financed these loans by borrowing Trinity funds that had been accumulated from the investors' initial personal payments. Through such loans by Trinity to Omega and by Omega to the investors, ¹ Omega was able to fund 5/7 of every electing investor's obligation to Trinity without an outside source of funding.

According to its promoters, the Mallas-Jones program offered significant tax savings to prospective investors. Under Treasury Regulation Sec. 1.612-3(b)(3), the advance minimum royalty was deductible at the taxpayer's option either when the royalty was paid or when the coal was mined and sold. For a deduction taken at payment, an investor who had received an Omega loan for 5/7 of the royalty obligation would receive $3.50 of deduction for every $1.00 invested. This opportunity attracted fifty-three investors to the leasing venture in 1977, and Mallas and Jones created a parallel 1978 program with eighty-nine investors.

According to the government, however, the annual minimum royalties were not deductible and the entire shelter was an illegal scheme to evade federal income taxes. The government raised two specific objections to the program. First, it maintained that Treasury Regulation Sec. 1.612-3(b)(3) authorized deductions only if Trinity, at the beginning of each lease, committed to that leasing investor enough coal property to recoup all of the annual advance minimum royalties due over the full four years of the lease. Trinity, which did not own that much coal, ² asserted to the contrary that the regulation required it to have sufficient coal to permit recoupment of the minimum royalty payments only at the time that each obligation became due. Under this interpretation, Trinity's holdings were satisfactory. Second, the government reasoned that the advance minimum royalties were not deductible because--upon close analysis of the loan network connecting Trinity, Omega, and the investors--the royalties had not been paid in "cash or its equivalent" as required by Helvering v. Price, 309 U.S. 409, 413, 60 S.Ct. 673, 675, 84 L.Ed. 836 (1940), and constituted an economic transaction in form but not in substance.

With these alternative government theories cast into criminal charges, a grand jury in the western district of North Carolina indicted Mallas and Jones on thirty-five counts for violations related to the alleged tax evasion. The two men stood trial in January 1984 and were each convicted on fourteen counts: one count of conspiracy to defraud the United States by defeating the lawful functions of the Internal Revenue Service, 18 U.S.C. Sec. 371; two counts of willfully claiming false deductions on their 1977 and 1978 tax returns for their own participation in the coal-leasing programs, 26 U.S.C. Sec. 7206(1); ten counts of aiding others in the filing of false returns based on those persons' investments in the program, 26 U.S.C. Sec. 7206(2); and one count of causing a person to travel interstate in furtherance of a scheme to defraud, 18 U.S.C. Sec. 2314. The court imposed prison sentences of twelve years on each defendant, fined Mallas $75,000 and Jones $40,000, and ordered them to pay the costs of prosecution and all taxes owed to the United States. This appeal followed.

II

We reverse. Grave penalties rest in this case on an unsubstantiated theory of tax law: that the defendants promoted fraudulent deductions if the Trinity coal holdings were not sufficient to warrant complete recoupment of all advance royalties at the beginning of the lease but were sufficient to warrant complete recoupment of all advance royalties as each annual payment fell due. ³ Whatever eventual success this proposition may enjoy as an interpretation of tax law--a destiny we do not influence here--present authority in support of the theory is far too tenuous and competing interpretations of the applicable law far too reasonable to justify these convictions.

"It is settled," this court observed in the analagous criminal tax case of United States v. Critzer, "that where the law is vague or highly debatable, a defendant--actually or imputedly--lacks the requisite intent to violate it." 498 F.2d 1160, 1162 (4th Cir.1974). Criminal prosecution for the violation of an unclear duty itself violates the clear constitutional duty of the government to warn citizens whether particular conduct is legal or illegal. See generally Note, Criminal Liability for Evasion of an Uncertain Tax, 81 Col.L.Rev. 1348 (1981). As Critzer indicates, this same requirement arises from the rule of 26 U.S.C. Sec. 7206 that only a "willful" tax evasion is criminal. Willful conduct under Sec. 7206, which the Supreme Court described in United States v. Pomponio as "voluntary intentional violation of a known duty," 429 U.S. 10, 12, 97 S.Ct. 22, 23, 50 L.Ed.2d 12 (1976), requires that the duty involved must be knowable. See also James v. United States, 366 U.S. 213, 221-222, 81 S.Ct. 1052, 1056-1057, 6 L.Ed.2d 246 (1961).

Whether annual advance minimum royalties that are recoupable from warranted coal reserves acquired after execution of a lease but before payment of the royalty may be deducted from gross income is a point of law that is "vague or highly debatable" in the sense identified by United States v. Critzer. ⁴ As the government concedes in its brief, the applicable Treasury regulation, Sec. 1.612-3(b), "does not explicitly state that an AMRP is deductible in the year paid only if there are sufficient reserves committed in the first year of a lease such that the total amount of all the AMRP's required under the lease can be recouped." The...