Blum v. Comm'r, 12–9005.

• Decision Date: 18 December 2013
• Docket Number: No. 12–9005.,12–9005.
• Citation: 737 F.3d 1303
• Parties: Scott A. BLUM; Audrey R. Blum, Petitioners–Appellants, v. COMMISSIONER of INTERNAL REVENUE, Respondent–Appellee.
• Court: U.S. Court of Appeals — Tenth Circuit

737 F.3d 1303

Scott A. BLUM; Audrey R. Blum, Petitioners–Appellants,

v.COMMISSIONER of INTERNAL REVENUE, Respondent–Appellee.

No. 12–9005.

United States Court of Appeals,Tenth Circuit.

Dec. 18, 2013.

Christopher Reimer of Long Reimer Winegar Beppler, LLP, Jackson, Wyoming, for Appellants.

Judith Hagley of the U.S. Department of Justice, Tax Division, Appellate Section, (Kathryn Keneally, Assistant Attorney General; Tamara W. Ashford, Deputy Assistant Attorney General; Gilbert S. Rothenberg, Attorney; Richard Farber, Attorney, Department of Justice, with her on the brief) Washington, DC, for Appellee.

Before HARTZ and TYMKOVICH, Circuit Judges, and JACKSON ^*, District Judge.

JACKSON, District Judge.

I. Introduction

This case comes to us on appeal from a decision of the Tax Court upholding the actions of the Commissioner of the Internal Revenue Service (IRS) invalidating a financial transaction as lacking economic substance and imposing two accuracy-related penalties for underpayment of taxes. We have jurisdiction to hear this appeal under I.R.C. § 7482(a)(1). The intricacies of this offshore financial transaction and the fog of plausible deniability surrounding it cannot make up for the clarity of the big picture: this was a transaction designed to produce nothing more than tax advantages, and the Tax Court was right to uphold the Commissioner's actions.

II. Facts

The taxpayer in question, Mr. Blum, is a successful businessman who founded Buy.com. In response to Mr. Blum's 1998 and 1999 federal income tax returns, the Commissioner of the IRS issued a notice of deficiency and penalties against Mr. Blum.¹ Mr. Blum challenged that notice in the Tax Court. He lost and subsequently appealed the ruling to this Court.

Mr. Blum's briefs describe a “hard-working and self-made business owner.” Indeed, Mr. Blum's accomplishments are numerous and impressive. Mr. Blum founded Buy.com which in 1998 set records as the fastest growing company in U.S. history. This achievement undoubtedly springs from Mr. Blum's drive and business acumen. Mr. Blum's success, it should be noted, was not necessarily the result of formal education or expertise. As he points out in his brief, he never graduated from college, nor does he have special expertise in the areas of federal income tax law, accounting, or stock market investment. Rather he is a business development expert, and he generally relies on others to counsel him on matters like tax and investment.

In 1996, Mr. Blum retained KPMG for accounting services. Mr. Blum's father vouched for the firm's reputation, and Mr. Blum has relied on them for years. He has also hired former KPMG employees. It was, by all accounts, a good and fruitful relationship.

In August 1998, Mr. Blum made two sales of Buy.com stock resulting in $45 million in capital gains. A KPMG accountant who previously worked on Mr. Blum's tax returns was aware of Mr. Blum's possible capital gains and referred him to Carl Hasting of KPMG's Capital–Transaction Group. Mr. Hasting met with Mr. Blum twice. At these meetings, Mr. Hasting pitched a transaction called OPIS (Offshore Portfolio Investment Strategy) to Mr. Blum. The transaction, it is now widely acknowledged, is a tax shelter. However, KPMG recommended the transaction to Mr. Blum before IRS and Congressional investigations revealed this information to the public. Mr. Blum claims he saw an investment opportunity; the Commissioner claims Mr. Blum saw a tax evasion opportunity.

At this point, a brief overview of the OPIS transaction will be helpful. The OPIS shelter is designed to create large, artificial losses for taxpayers by allowing them to claim a large basis in certain assets. These artificial losses offset actual capital gains, reducing the tax liability of the participating taxpayer. A basis is, to oversimplify, the capital cost of an asset. IRS Topic 703—Basis of Assets, available at www. irs. gov/ taxtopics/ tc 703. html (last visited Oct. 16, 2013). There are technical rules that allow certain related parties in a financial transaction to claim a basis that, in reality, does not reflect the amount that the party paid for the asset. In fact, the party might not have actually purchased the asset at all. OPIS took advantage of this technical rule to allow clients to pay a relatively small amount of money in order to claim a disproportionately large basis and to use that basis to shelter their own otherwise taxable income. See generally Staff of S. Comm. on Gov't Affairs, Permanent Subcomm. on Investigations, 108th Cong., Rep. on U.S. Tax Shelter Industry 5–10, 28 (Comm. Print 2003) [hereinafter Senate Report].

Individual components of this transaction presented the possibility of profit. No one, however, argues that profits were likely. Indeed, while the parties dispute the method used to calculate the likelihood of profit, both agree profits were unlikely. Rather, according to Mr. Blum, the small chance of huge profits justified the risk of such an investment.

According to Mr. Blum, he never discussed the tax effects of the transaction with Mr. Hasting. Tr. 65–66.² He also cannot remember discussing OPIS with any of his other advisors. Nevertheless, after a second meeting with Mr. Hasting, Mr. Blum signed an Engagement Letter with KPMG that indicated KPMG would receive a fee of $687,500 in exchange for serving as a tax advisor to Mr. Blum on the OPIS transaction. Ex. 12–J. Mr. Blum does not recall reading this engagement letter.

It appears that Mr. Blum left the management of his OPIS investments to KPMG. As a result, he claimed $45 million in losses on his 1998 income tax returns. Mr. Blum filed those returns on April 15, 1999. The next month, KPMG provided Mr. Blum with an opinion letter that explained the legal justification for these financial transactions and concluded that the IRS would “more likely than not” view the transactions as legitimate. Ex. 98–P.

These sorts of basis-shifting transactions caught the IRS's attention in 2001. According to the GAO, abusive tax shelters may have deprived the U.S. Treasury of between $11 and $15 billion per year during the 1990s. Sen. Rep. at 20. Extensive investigation by the IRS and U.S. Senate revealed a widespread practice of using basis-shifting to create paper losses for clients, thereby reducing their tax bills. The investigation revealed that even within KPMG there was concern about the potential illegality of these transactions. One memorandum went so far as to call the economic substance of these deals “smoke and mirrors.” Id. at 41. The Senate Report concluded that KPMG might have bullied or misled clients into signing off on certain factual representations underlying the transactions. For example, the Senate Report observes that in certain cases “KPMG alone, apparently without any client input, wrote the client's representations and then demanded that each client attest to them by returning a signed letter to the accounting firm.” Id. at 68.

The IRS formally disallowed OPIS and similar transactions in 2001. I.R.S. Notice 2001–45, 2001–2 C.B. 129. Rather than individually prosecute each OPIS scheme, the IRS settled with over 90 percent of OPIS purchasers in 2003. Johnson, Tales from the KPMG Skunk Works: The Basis–Shift or Defective–Redemption Shelter, Tax Notes 431, 433–34 (July 25, 2005). Mr. Blum did not accept the settlement offer.

These revelations occurred after Mr. Blum participated in OPIS. Nonetheless, in 2005, the IRS sent a deficiency notice to Mr. Blum regarding his 1998 and 1999 federal income tax returns. This notice disallowed the losses Mr. Blum claimed in connection with OPIS, and it imposed penalties for a gross valuation misstatement (I.R.C. § 6662(h)) and negligent underpayment (I.R.C. § 6662(b)). Mr. Blum challenged this notice in the Tax Court in February 2006. The Tax Court rejected his challenge, concluding that the Commissioner was correct to disallow the claimed losses under the economic substance doctrine, and that both the gross undervaluation and negligence penalties were appropriate.

Mr. Blum also filed a civil case against KPMG for fraudulent misrepresentation in the Central District of California in 2011. After the Tax Court approved the negligent underpayment penalty, the District Court ruled that such a finding collaterally estopped Mr. Blum from arguing that he relied on KPMG's advice that OPIS was a legitimate investment strategy. Blum v.

KPMG, LLP,

No. SACV 11–01885–CJC (C.D.Cal. July 17, 2012) (Order).

In his appeal to this Court, Mr. Blum makes three arguments: (1) that the Tax Court erred when it disallowed the OPIS losses under the economic substance rule; (2) that the Tax Court erred by imposing a penalty for a gross valuation misstatement after it concluded the underlying transaction lacked economic substance; and (3) that the Tax Court erred by imposing penalties for negligent underpayment, because Blum relied in good faith on KPMG's representations. The Commissioner continues to maintain that the transaction lacked economic substance, and that the gross valuation misstatement and negligence penalties are warranted.

We affirm the opinion of the Tax Court and note that the question of whether Mr. Blum is collaterally estopped from arguing that he reasonably relied on KPMG's advice in good faith is not before this Court.

III. DiscussionA. Disallowance of OPIS Losses

Quixotically, Blum maintains that the OPIS transaction presented a reasonable probability of generating a profit. It follows, he argues, that the Commissioner was wrong to disallow the losses he claimed as a result of the transaction, and the Tax Court was wrong to validate the Commissioner's action. In a nutshell, Mr. Blum argues that the Tax Court applied the wrong test to determine whether the transaction lacked economic substance, that it improperly ignored the testimony of one of two dueling expert witnesses, and that it committed clear error by finding that Mr. Blum lacked the...